Notes to the Financial Statements
The notes to the financial statements (sometimes called footnotes) are also an integral part of the overall picture. If the income statement, balance sheet, and statement of cash flow are the heart of the financial statements, then the footnotes are the arteries that keep everything connected. If you aren't reading the footnotes you're missing out on a lot of information.
The footnotes list important information that could not be included in the actual ledgers. Could you imagine if the company listed out individual expenses on the income statement instead of putting them under one or two neat headings? The income statement would be 20 pages long!
The notes will list relevant things like outstanding leases, the maturity dates of outstanding debt, and even details on where the revenue actually came from. Generally speaking there are two types of footnotes:
- Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business. This portion of the footnotes will tell you the nature of the company's business, when its fiscal year starts and ends, how inventory costs are determined, and any other significant accounting policies that the company feels that you should be aware of. This is especially important if a company has changed accounting policies. It may be that a firm is practicing "cookie jar accounting" and is changing policies only to take advantage of current conditions to hide poor performance.
- Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt such as maturity dates and the interest rates at which debt was issued, can give you a better idea of how borrowing costs are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to details about ominous legal proceedings the company is involved in.
The majority of investors and analysts read the balance sheet, income statement, and cash flow statement. But for whatever reason, the footnotes are often ignored. What sets informed investors apart is digging deeper and looking for information that others typically wouldn't. No matter how boring it might be, read the fine print, it'll make you a better investor.