How To Guide: Reading An Earnings Report

Remy Merritt |

Earnings reports are pretty intimidating. For companies, it means they must comprehensively report all movements of money within and without the business. And for investors, they mean having to learn how to read both between the lines as well as the numbers on the lines themselves. For an outsider or newcomer like myself, it can all appear to be complex financial gibberish. However, that doesn’t mean it’s not important to understand what it all means.

These reports are the key components that link the general public to capital markets, laying necessary details out for new and seasoned investors alike so that all can tap into the opportunities of investing in corporate capitalism.

Like Clockwork. Complicated, Complicated Clockwork.

Companies release four earnings reports each fiscal year: three unaudited quarterlies (10-Qs) and one audited annual (10-K). It is up to the company to balance their own 10-Qs, but outside auditors are hired to be sure the annual 10-K is fully accurate.

The United States’ federal fiscal year begins on October 1 and ends September 30, but most public companies’ calendars begin on January 1. With the latest close of the April-June quarter, this week is the beginning of earnings report season — the next 10-Q is due by August 14.

To ease into the details, I’ve created a hypothetical t-shirt manufacturing company, The Shirt Stop, as the example. This is a large franchise with stores located across the United States, and offers membership to Club Shirt Stop for a small monthly fee. The vocab for some of these financial categories can be opaque and seem unclear (hint: depreciation isn’t a measure of the hate mail a company receives), but what those words actually mean is far less daunting than appears. Stick with it, and by the end of this you’ll be reading earnings reports like Warren Buffet!

Accompanying Earnings Brochures Are Generally Incomplete

 

Don’t rely on them! Along with the official financial reports, companies release glossy brochures to shareholders that often (almost always) paint a rosier picture of the company’s quarterly performance. Though they cannot be outright untrue, these reports are not heavily regulated and are written with as much of a positive spin as possible. The most valuable reports are those with specific numbers — the numbers can’t lie.

The Quarterly 10-Q

These three reports are due within 45 days after the end of each fiscal quarter. They include four main financial breakdowns: (1) balance sheets; (2) income statements; (3) cash flow statements; and (4) statements of shareholders’ equity.

(1) Balance sheets

A sample balance sheet is included below, with assets found on the left and liabilities and equity on the right. The two sub-columns within the two main columns allow for easy comparison to the previous year’s data.

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Balance sheets deduct a company’s liabilities and debts — essentially everything it owes to anyone — from its assets — essentially everything it owns — at a fixed point in time. A company’s assets must equal the sum of its liabilities and shareholders’ equity. All assets are essentially the entire worth of a company: everything it could potentially sell in the event it decided to be bought out or shut down entirely, including investments. All liabilities are the current and future debts it owes, and equity is the money that would be left over if a company sold all its assets and paid all its liabilities. With this logic, liabilities minus equity should balance to equal assets.

Assets are organized based on how quickly they can be converted into cash. Current assets, such as inventory, are generally listed at the top and are expected to earn cash within one year. For The Shirt Stop, this would be any fabric or completed shirts that will soon be shipped and sold. Noncurrent assets, often fixed equipment, are those that the company does not plan to convert into cash or that would take longer than one year to sell. Noncurrent assets for The Shirt Stop would include the factory where shirts are made, the equipment in the plant, and the trucks used to ship deliveries to stores and customers.

Most items on this list are self-explanatory, but some are a little more elusive. If this were The Shirt Stop’s balance sheet, marketable securities could be government bonds it is holding as investments. Accounts and notes receivable denote money owed by customers that will be paid in the future, usually in the form of credit.

Depreciation here is in parentheses to indicate a loss, a standard piece of formatting throughout all balance sheets. Another one of these red parentheses pops up under equity as “Treasury Stock” – this is included if the company has chosen to buy back stock.

As you can see, total assets equal total liabilities and owners’ equity. Easy!

(2) Income statements

Below its introductory balance sheet, the Shirt Stop’s income statement goes deeper into the company’s money movement. The income statement shows all the company’s earnings and expenses over the previous three months. They report revenue alongside costs and expenses to reveal the proverbial ‘bottom line;’ that is, how much the company earned or lost over the period.

Earnings per share (EPS) is included in this section, which shows how much money shareholders would receive per share should the company decide to distribute all earnings to investors. EPS is calculated by taking the company’s net income and dividing by the number of outstanding shares of the company. This is, of course, hypothetical as most of these earnings are actually reinvested in the business rather than investors’ pockets, but it’s still helpful to consider how much money each share of stock theoretically represents.

Income and expenses are important, so let’s dig a little deeper. You’ll find the following subcategories on the income statement, and, while they appear pretty complicated at first blush, they’re really a lot simpler than they appear.

Revenue vs. Sales

While they may be colloquially interchangeable, revenue and sales have subtle differences. When a corporation reports sales, it is measuring the income from direct sales to the public or its distributors. The Shirt Stop’s sales would be primarily from completed t-shirt sales, but could also include sales of materials if it opened a branch that sold original Shirt Stop fabrics. Alternatively, revenue measures indirect or ancillary income. This secondary source of income could come from membership fees to Club Shirt Stop, or revenue the business collects from franchisees.

Operating Costs and Expenses

Although corporations are considered people and, in that sense, are much bigger people than we are, they too are subject to running up their credit and owing money in order to function. There are a variety of expenses required to run a business: cost of sales; selling, general and administrative expenses (SG&A); depreciation; and amortization.

Cost of Sales and SG&A

Cost of sales, also known as cost of goods sold, includes every expense required to manufacture a company’s product. This includes purchases of fabrics, labor, storefront rent (also known as ‘occupancy’), et cetera. SG&A track expenditures related to corporate management and include advertising, legal payments and accounting. For Club Shirt Stop, this could include perks offered to club members. These costs are separate from the cost of sales because they are not directly related to sales of the manufactured product.

Depreciation and Amortization

Here is an example of bizarre terminology for something that is actually pretty simple. These two homonyms have a very similar meaning and relate to the expensing of corporate holdings over time. Think of them in terms of a car — over time, the car loses value. This is the same for corporate equipment: depreciation relates to the tangible, while amortization refers to the intangible. Depreciated goods at The Shirt Stop include recurring payments on a new factory or piece of machinery. Amortized goods include intangible assets such as their trademarked shirt designs. This often comes into play when one company purchases another at a premium; the excess of the purchase price is called “goodwill,” and it represents the additional amount the purchaser pays for the company’s depreciated and amortized assets.

(3) Cash flow statements

As a college student, I’m all too familiar with negative cash flow. A company’s cash flow statements track the movement of cash into and out of its accounts to make sure it isn’t stuck in negative outflow and piling on debts. These statements also demonstrate how much cash the company has on hand to pay expenses and purchase assets. It provides a deeper analysis of the income statement to determine not just whether a company made profit, but also whether cash was generated.

There are three types of cash flow, generated through operating, investing, and financing activities. These statements track the company’s exchange of money with other companies. The Shirt Stop’s operating expenses may include shipping products, investing may include a one-time purchase of a new industrial sewing machine, while financing could come from a purchase of government bonds to earn The Shirt Stop its own revenue from investment holdings.

(4) Shareholder’s Equity — That’s You

Statements on shareholders’ equity occur throughout the financial details, but the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (MD&A) is the management’s opportunity to provide its own view of the company’s health and performance. It is written to investors and notifies them of what the financial statements don’t explain. This is where investors can find information about trends and risks that involve the past and future of the company.

For example, if a hurricane damaged a major Shirt Stop factory, this event would likely be included in the MD&A to explain any unusual net losses for the quarter. Widespread effects could reach to all aspects of the earnings report. Cost of goods sold could increase because The Shirt Stop now has to increase paid labor at its remaining plants to make up for the difference and keep inventory strong. Its long-term debt could skyrocket with the addition of a factory that needs to be rebuilt.

Along the same lines, a Form 8-K may be released in the interim if a major event occurs that is important to company shareholders or the SEC. Occurrences such as a bankruptcy or the departure of a CEO also fall under this category, and a public company is required to reassess the previously filed 10-Q and/or 10-K.

The Annual 10-K

We're not talking about a 6.2 mile running race here - in the corporate world, the 10-K is the big kahuna of financial reports. It takes into account components such as a company’s history, audited financial statements, executive compensation and additional management discussion and analysis, and it is due within 90 days after the end of the company’s fiscal year. For larger companies, it is due within 60 days. It includes all of the data on assets, liabilities and equity found in a 10-Q, but in greater detail.

To GAAP or not to GAAP?

Following “Generally Accepted Accounting Principles” (GAAP) sounds like a given, but creating a system standard is necessary regardless of the system at hand. The standards offer uniformity across a wide range of companies and sectors. Adjusted non-GAAP earnings statements are useful when a company has just made a large one-time purchase that may distort an earnings report that would otherwise appear normal. In general, GAAP reports will understate earnings while non-GAAP reports will overstate.

Earnings Before Interest, Taxes, Depreciation and Amortization (EBIDTA, or operational cash flow) is an example of a non-GAAP report that is useful for companies with, for example, large amounts of fixed assets. There, depreciation may result in a significant drop in income. If The Shirt Stop were manufacturing-based, EBIDTA would be an important component that accounted for the depreciation of its many factories and equipment. Many companies provide both outlooks for a comprehensive view of the quarter’s financial activity.

To Invest or Not to Invest?

With this new knowledge of how to read the various sheets of numbers that companies pump out each quarter, hopefully you feel better equipped to judge the value of a company on your own. The Internet is always a useful tool if you come across part of the earnings report that isn’t totally clear – Investopedia and About.com have explanations for just about everything related to finance for the average investor. Stocks move up and down for a variety of reasons, but a company’s earnings report is the best indicator of its true value over time.

 
 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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