How to read a 10-K for the number that matters

Start at the back, in the notes

The income statement is a summary. The notes are the document. Three of them carry most of the information: the segment note, which splits revenue and operating profit by business and often reveals that one segment funds everything else; the revenue recognition policy, which tells you when a sale is booked and therefore how much judgement sits inside the top line; and the commitments and contingencies note, which is where litigation, guarantees, and obligations that do not appear on the balance sheet are disclosed.

If you read only the segment note and the cash flow statement, you will understand a company better than someone who read the entire management discussion. Segment disclosure is where a growth story either has a source or does not.

Cash flow before income, every time

Net income is an opinion supported by policy choices. Cash from operations is closer to a fact. The comparison worth making is not the level of either but the gap between them and how that gap behaves over several years. Persistent operating cash flow far below net income means the earnings are being created by accruals. Persistent cash flow above it usually means heavy non-cash charges, which may be perfectly benign.

Then look at the composition. Stock-based compensation is added back as a non-cash expense and it is a real cost paid in shares, so a company whose free cash flow depends on that add-back is funding operations by diluting you. Capitalised software and development costs move spending off the income statement and into investing, flattering margins. And receivables growing materially faster than revenue is the single most reliable early signal that sales are being pulled forward or that customers are struggling to pay.

• Compare operating cash flow with net income over five years, not one.
• Subtract stock-based compensation and see whether free cash flow survives.
• Check receivables and inventory growth against revenue growth.
• Read capital expenditure against depreciation to see whether the asset base is being maintained.

Do not read the risk factors, diff them

Risk factors are almost entirely lawyer-written boilerplate carried forward year to year, and reading them cold is a waste of an hour. What they are good for is comparison. Pull this year’s and last year’s, run a text diff, and read only what changed. A newly added risk factor is a disclosure decision someone made deliberately, usually because a lawyer concluded the exposure had become material. A quietly removed one is equally informative.

The same technique works on the accounting policies and on the critical audit matters in the auditor’s report. Changes are signal. The stable text is furniture.

The non-GAAP reconciliation is the argument

Adjusted earnings are the company telling you which costs it would like you to ignore, and the reconciliation table lists them individually. That table is the most opinionated page in the filing and it is often the most useful. Two questions settle it. Are the same adjustments appearing every single year, in which case they are not one-time anything, they are the cost of running the business. And do the add-backs include real cash costs, restructuring paid in cash, acquisition expenses, litigation settlements, in which case the adjusted figure describes a company that does not exist.

Our position: the front of a 10-K is written for the quote and the back is written for the regulator, so read the back. If you are short on time, spend it on the segment note, the cash flow statement, and the reconciliation, and skip the management discussion entirely. Nothing in it will be absent from those three, and everything in it has been framed.