The earnings report is a key way for a publicly traded company to tell current and potential investors how it sits financially. Because it is such an important document, and because it is released by the company itself, investors should realize that it is in the company's best interest to present as rosy a picture as possible without violating any Securities and Exchange Commission (SEC) regulations.
Unfortunately, many investors are unable to effectively decipher an earnings report. While the reports are prepared by companies without the intent to deceive investors about company health outright, investors should still take the information found in them with a grain of salt. Reading between the lines to decipher a company's true financial condition is the key to understanding earnings reports.
Earnings Report Vs. 10-Q Filing
Companies are legally required to file a quarterly report, the 10-Q, an annual report and the 10-K with the SEC. The 10-Q contains financial information, such as the income statement, balance sheet and the stockholders' deficit and cash flows. It also has management's discussions and analysis of financial conditions and results, disclosures of market risks facing the company and notes about controls and legal proceedings. Large companies might have 10-Q documents longer than 100 pages.
Companies typically post a press release summarizing what is found in the 10-Q. The press release often contains nothing more than a few paragraphs of information, a statement from executives and outlines some of the key elements of interest to investors, including revenue, net income, cash flow, earnings per share and EBIT.
The Form 10-Q, however, is the black and white, no-frills document that is submitted to the SEC. While more boring and a lot longer than the earnings press release, the 10-Q carries more significance for investors because it contains a wealth of information that cannot be glossed over. While elements of the earnings report can fall into the realm of marketing material, companies releasing them cannot fudge the numbers without risking SEC ire.
The Components of an Earnings Report
For a quick snapshot of the major tenets of what's going on with a company, reading the earnings press release is a good start. Investors who are interested in buying shares in a public company and want to make an informed decision should examine the 10-Q filing. It is important to note, however, that the financial statements are not audited.
The components of the quarterly 10-Q filing are:
Part I: Financial Information
- Item 1: Condensed Consolidated Financial Information
- Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations
- Item 3: Quantitative and Qualitative Disclosures About Market Risk
- Item 4: Controls and Procedures
Part II: Other Information
- Item 1: Legal Proceedings
- Item 1A: Risk Factors
- Item 2: Unregistered Sales of Equity Securities and Use of Proceeds
- Item 3: Defaults Upon Senior Securities
- Item 4: (Removed and Reserved)
- Item 5: Other Information
- Item 6: Exhibits
How to Tackle This Document
Earnings reports can be reviewed and interpreted in different ways by different investors. Some prefer skipping the opening sections on financial data to read about management's take on the market and the risks facing the company. Some prefer jumping right into the numbers and comparing those to previous quarters and years. Regardless of how you look at the report, going about its review methodically will help you understand what is going on.
The first part of the document outlines what company is filing the report, for what period, what state the company is incorporated in, tax identification information and the primary business location. The report will then list a table of contents indicating which sections are found on which pages.
You should then move on to Part I (Financial Information) and examine and analyze the financial data. Some investors go after the "buzz" items, such as revenue, net income attributable to common stockholders, diluted earnings per share and EBIT. While these are important, make sure to dig deeper.
- How did the company perform over the last quarter?
- How did the performance compare to the previous quarter, or to the same quarter in previous years?
- Have revenues improved or taken a hit?
- Is the cost of sales increasing, meaning that it is more expensive to bring in revenue?
Look over the cash flow statement to see if the company is earning cash from continuing operations or is using it. Companies might have negative cash flow but are still able to show positive net income. If things look fishy, remember that you can always walk away and not buy the stock.
Financial Risk Factors
Once you have a sense of a company's financial health, it's time to check out the risks that it might be facing in the coming quarters. Move on to Part II (Other Information) and check out Item I (Legal Proceedings). If a company has outstanding lawsuits, it has to report them along with a brief description of what the lawsuits are about. The company won't necessarily attach a price tag to a particular legal problem, so you will want to examine the nature of the lawsuit. Consider the potential financial impact of the lawsuit compared to the overall value of the company. Many companies face relatively small damage claims each year, but may sometimes face a giant lawsuit that can have a major financial impact (think pharmaceuticals and big tobacco).
Also review Item 1A (Risk Factors). Information here will be detailed and straight to the point, primarily because this is a document filed with the SEC and companies have to be honest and forthcoming. You may see statements such as "inadequate liquidity could affect our future operations" or "given the current environment our operations do not generate sufficient cash." Consider whether the risks are part of a general market trend, such as lower sales during a recession, or if they are part of a larger problem, such as revenue coming from one or two sources rather than a diversified set of customers.
The Bottom Line
You don't have to be a big-time equities analyst to get an idea of what an earnings report is telling you. Use what you know about stocks and financial strength to determine your best course of action, and think twice before spending a lot of time using techniques employed by sophisticated investors if you won't know how to interpret the results. There are a lot of publicly traded companies posting earnings reports each quarter, so don't feel behind schedule just because you aren't reading every report. Concentrate on stocks that are of interest to you, and remember that even if the information found in the earnings report makes you not want to buy the stock, reading it was still a worthwhile activity. After all, it saved you from making a bad choice.
To get into the more technical aspects of reports, check out our Financial Statements Tutorial.