Annual reports generally contain three key sections: management’s message to shareholders, a discussion of the company’s operations, and the financial statements. Keep these points in mind when reviewing the annual report:

• Read the independent auditor’s report. In most cases, you’ll find an unqualified opinion stating the financial statements were audited in accordance with standards of the Public Accounting Oversight Board and present fairly, in all material respects, the financial position of the company for the last three years. You’ll want further details if the report indicates problems, concerns about the company’s ability to stay in business, or incidences where the financial statements do not follow generally accepted accounting principles. Many companies have changed auditors in recent years to reduce costs or for other factors. Make sure, however, that any auditor changes are not a result of disputes with the auditors.

• Review management’s discussion carefully. You want to feel comfortable that management is candid and straightforward about the company’s results and is not glossing over problems or concerns. You should get a feel for the company’s future prospects, its competitive position, and any significant risks to business operations.

• Look for important facts in the footnotes. Information about outstanding litigation, class action suits, derivative exposure, environmental problems, and unfunded pension liabilities can be found here, alerting you to potential problems. Changes in accounting policies will also be discussed, which may indicate that management is making changes to improve financial results. You can also find important information about the company’s business, including whether any customer accounts for more than 5% to 10% of sales, how much is spent on advertising and research and development, what shareholders’ rights plans are in effect, how many stock options are outstanding, information on acquisitions and divestitures, and details on business segments.

• Analyze financial trends over at least a three-year period. Review whether sales and profits are increasing or decreasing. Also, calculate the profit margin (net income divided by revenues) and the return on equity (profits divided by average shareholder equity), comparing these to prior years and to ratios for other companies in the same industry.

• Review the company’s financial solvency. Calculate the current ratio (total current assets divided by total current liabilities) to track the company’s ability to pay creditors over the short term. Longer-term solvency can be measured by dividing total liabilities (the total of current liabilities, long-term debt, other liabilities, and deferred income taxes) by total assets. Compare these numbers to the company’s figures from prior years and to other companies in the same industry to see if there is cause for concern.