Earnings season is judgment day for stocks. It happens four times a year, after the last month of each quarter (March, June, September, December), as public companies release their earnings results from the previous quarter. Traditionally, Alcoa (AA)’s results “kick off” the season, and away we go.
Federal securities laws require companies to disclose revenue and earnings in a standard format that gives investors a view of its financial position—a report card of sorts—this info isn’t always the easiest for the average investor to decipher and tell exactly what a company is trying to say—or trying not to say.
But that doesn’t mean that this is rocket science. If you can read the side of a cereal box for its nutritional facts, then you can read a financial statement. And there are a handful of important numbers that will be able to tell you the financial health and growth of a company in a few short minutes.
First, let’s take a look at the three most important aspects of a financial statement:
Financial Statements Made Easy
An income statement will show you two things—how much a company earned for the year or quarter, and how much it spent in earning that revenue. When reading an income statement, start at the top, then go down each number and subtract the expenses until you reach the “bottom line,” which will tell you how much the company earned (or lost) over the period.
The first number is usually labeled gross revenue or net sales. This is the total amount of revenue brought in from the sale of product or services.
Next we have to subtract expenses. First is the cost of sales—what the company spent in creating goods and services. We also subtract operating expenses like research, marketing or administration, as well as depreciation of assets, which takes into account the wear and tear on long-term assets like machinery during the time period. And finally, we have to account for interest income and interest expenses, as well as taxes that need to be paid.
After all these expenses are deducted, we arrive at the bottom line—net profit or net losses, which will tell you whether the company made or lost money.
This is also where we get the all important earnings per share, or EPS. This is just the total net income of the company, divided by the number of outstanding shares. EPS tells you how much money shareholders would receive for each share of stock they own if the company distributed all of its net income for the period.
A company’s balance sheet will tell you all about a company’s assets, liabilities and shareholder equity. Assets have to equal the sum of a company’s liabilities and equity.
First up, we have assets. These are all the things that a company owns in order to operate its business that have value—physical property like plants, trucks, equipment and inventory, as well as intangible assets like goodwill, trademarks and patents.
On the other side of the balance sheet are liabilities—financial obligations that the company owes. This can be money borrowed from a bank, rent for a building, money owed to suppliers, payroll for employees or taxes owed to the government.
Finally, shareholder’s equity—sometimes called capital or net worth—is money that would be left if a company sold all of its assets and paid off all of its liabilities. If, at the end of the year, a company reinvests its net earnings into the company, the earnings will be transferred onto the balance sheet into the shareholder’s equity account. Other times, a company may choose to distribute earnings through dividends instead of retaining them.
And I have to say, although I will never recommend stocks solely based on dividends, the yield of a company is indeed a factor I look at.
A cash flow statement shows how a company is paying for its operations and future growth by detailing how cash “flows” back and forth from a company. No business can survive for long without generating positive cash flow per share for its shareholders. As such, a company’s long-term cash inflows need to exceed its long-term cash outflows.
Often, cash flow statements are divided into three main parts: Operating activities reconciles the net income with the actual cash the company received from or used in its operating activities. Investing activities shows the cash flow from all investing activities, which generally include purchases or sales of long-term assets. And finally, financing activities includes cash raised by selling stocks and bonds, borrowing from banks, as well as stock buybacks or paying back bank loans.
Cash flow is one of the big items that I dig into when recommending individual stocks. When you combine strong cash flow with solid sales and earnings growth, you have the beginnings of a solid company.
Now, it’s important to note that just because a company is bringing in cash, it doesn’t mean that it’s profitable—and vice versa—but as long as you have a good handle on all three of these aspects of a financial statement, you should be well on your way to understanding the nitty-gritty of a company.