How to Decode a Company's Earnings Reports

The earnings report is the predominant method for a publicly traded company to report its financial results for a period. Investors can use a company's earnings report to gain insight into how well a company is run and whether the company is performing well. However, it's important to note that earnings reports often present a rosy picture of the company's financial situation. As a result, it's important to learn how to read and decipher an earnings report so you can separate the management team's sales pitch from reality.

Companies typically issue a press release highlighting the contents of 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 dividends.

Companies will also release a presentation deck for investors that contains the financial highlights and success from the period. However, the deck is prepared for the investors and typically contains a very positive message.

The Form 10-Q, on the other hand, is a no-frills document that is submitted to the Securities and Exchange Commission or SEC. The 10-Q carries more significance for investors because it contains a wealth of information. While elements of the earnings report can fall into the realm of marketing material, companies releasing them cannot fudge the numbers without risking an SEC violation.

Companies are legally required to file a quarterly report, a 10-Q, an annual report, or the 10-K with the SEC.

The 10-Q contains financial information including:

• income statement
• balance sheet
• the statement of cash flows
• management's discussions about the earnings results and overall financial conditions
• disclosures of market risks facing the company.

It's not uncommon for large companies to have 10-Q documents longer than 100 pages. 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 first part of the document outlines which 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.

The first major section contains the financial information. Key areas of focus should include revenue, net income, earnings per share, and EBIT or earnings before interest and taxes. While the above financial figures are important, make sure to ask the following questions:

• 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 on a quarter-to-quarter basis?
• Is the cost of sales increasing, meaning that it is more expensive to bring in revenue?

Review the cash flow statement to see if the company is earning cash from continuing operations. Companies might have negative cash flow but are still able to show positive net income.

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 the lawsuits. 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 some companies might face a larger expense from ongoing litigation.

Also, review Item 1A (Risk Factors). 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.

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.

You don't have to be an equity analyst to read and understand an earnings report. Although there are many publicly traded companies posting earnings reports each quarter, concentrate on stocks that are of interest to you. Please remember that even if the information found in the earnings report makes you avoid the stock, reading the report is 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.