Welcome to lesson three of our course on how to pick stocks! Lesson one looked at setting investment goals and lesson two looked at how to analyse those stocks with quantitative analysis. I lesson three we will look at earnings reports and how to read them. We will cover:

• The three sections that make up earnings reports
• What these sections tell you about the company

By the end of this lesson you should be able to:

• Understand earnings reports and the information they contain
• Use this information to help make investing decisions

Lets get started!

 

Understanding Earnings Reports for Stock Pickers

Twice a year Aussie investors have the opportunity to check the health of the stocks they have picked for their investment portfolio as all ASX listed companies are required to report financial results at six month intervals. Full Year Financial Reports cover an entire fiscal year, followed by Half Year Financial Results for the first half of the upcoming fiscal year.

Since 1896, publicly traded companies in Australia have been required by law to publish an audited financial statement annually. The system has been revised over time to expand the single financial statement to three separate but integrated financial disclosure statements, audited by a professional accounting firm outside the company.

In the 1920’s ratio analysis became a popular tool for stock pickers to use in their shopping for investments. Professional certified financial analysts scoured financial statements to identify and quantify meaningful relationships between numerical line items in the statements to enable more meaningful evaluation of a company’s health. Regardless of how much individual investors rely on ratio analysis tools, understanding the quantitative data from which they were derived is an important part of the process of stock picking.

There are three component statements in corporate financial reporting:

• Income Statement
• Balance Sheet
• Statement of Cash Flows

For each of these statements, stock pickers need to know what is in the statement, what the items mean, and what to look for to better assess the health and outlook of the stock.

 

The Income Statement

Also known as the P&L (Profit and Loss), the Income Statement tells you how much the company made, spent, and had left over as profit, or net income. Net income is the end result after what the company spent — expenses — are subtracted from what the company made – revenues. If the company spent more than it made, the net income is negative.

Sounds simple and logical, but the first glance of the seemingly endless litany of line items may leave average retail investors dazed and confused. In truth, most of these are of more interest to the professionals who will fine tune the statement than they are to ordinary retail investors interested in the basics of what is most important.

The critical things to look for on an income statement are:

• Total Revenues – known also as the top line
• Cost of Goods Sold
• Gross Profit
• Operating Expenses
• Operating Income
• Interest and Taxes and
• Net Income, or the fabled bottom line.

Follow the progression as one line item is subtracted from the item above on the downward trek to net income or profit.

An Income Statement will list three consecutive years of reporting, allowing investors to spot positive and negative movement over time. Some financial websites and online trading platforms post five or even ten consecutive years of results.

The Income Statement is arguably the most important to investors as it cuts to the core of the number in which they are most interested – net profit. It also points to a key problem for many companies – operating expenses. When impressive total revenues and gross profit shrink to miniscule net income, the culprit is almost always operating expenses.

 

The Balance Sheet

From the Income Statement, net income appears on the Balance Sheet under retained earnings while interest expense listed on the income statement moves to the debt line item on the balance sheet.

On the income statement investors look for revenues and profit. Here investors look at a company’s assets, liabilities, and shareholder equity to assess the company’s liquidity and solvency.

There are three main components within the balance sheet – Total Assets, Total Liabilities, and Shareholder Equity. This statement must “balance out” where the three sections follow the basic accounting function that states shareholders equity = assets – liabilities. In simpler terms,– shareholder equity – is calculated by subtracting all the company owes from all the company owns. Shareholder equity also includes paid in capital from issuing shares and retained earnings not paid out in shareholder dividends.

Total assets include everything the company owns:

• Cash on hand and cash equivalents (investments that can be converted to cash quickly)
• Property, plants, and equipment
• Inventory and
• Accounts and other receivables.

Total Liabilities include both current (due within one year) and non-current (due beyond one year). Current, or short-term liabilities include:

• Money owed to suppliers (accounts payable)
• Short-term debt including interest payments on debt
• Accrued expenses not yet paid (salaries, utilities and other costs)
• Payments received for goods and services not yet delivered (unearned revenue)
• Taxes and dividends payable.

Non-current, or long term liabilities include:

• Long term debt,
• Bonds payable,
• Lease payments,
• Deferred tax payments, and
• Pension obligations.

Trends are what investors should look for on a balance sheet, especially on short and long term debt obligations. Increasing long term debt levels is not a good sign of company solvency. Declining levels of cash, cash equivalents, accounts receivable, and short-term debt are not a good sign of company liquidity.

Reading a balance sheet should be done in conjunction with evaluating financial ratios derived from the balance sheet, like the debt to equity, current, quick, and cash ratios, among others.

 

The Cash Flow Statement

The Cash Flow Statement looks at a company’s financial health by tracking how cash flows into the company’s front door (inflows) and out its back door (outflows). There are three main sections:

• Cash flow from operations,
• Cash flow from investing, and
• Cash flow from financing

Cash flow from operations is the most critical of the three statements. It shows the sources of cash that flow in and the sources where it flows out. Inflows include:

• Cash received from customers
• Cash received from investment interest and dividends
• Cash received from tax refunds.

Outflows include:

• Cash paid for suppliers and employees
• Cash paid for operating expenses
• Cash paid for loan interest and income taxes.

Cash flow from operations should be positive and rising. Higher net income from the income statement is a sign the company is not converting its income into cash.

 

Cash flow from investing flows out from a company’s capital expenditures to buy long term assets like property, plants, and equipment, acquire new businesses, invest in securities, and any other expense to fund the company’s growth. Inflows come from selling long-term assets, divesting subsidiary companies, and collecting loan payments.

Negative cash flow from investing is a positive sign the company is aggressively pursuing future growth, provided the cash flow from operations can sustain the expenditures.

Cash flow from financing has inflows from issuing new stock to investors and from borrowing money. Outflows come from loan repayments, dividend payments to shareholders, and stock buybacks. For cash flow from financing, investors need to check debt against revenue growth from the income statement. Excessive debt needs to be supported by revenue. On the positive, share buybacks and consistent and rising dividend payments are a sign financial strength and the company’s confidence in that strength.

Negative cash flow from financing may be appropriate for mature and financially stable companies paying off debt and increasing dividends. Positive cash flow from financing may be appropriate for less mature company’s aggressively borrowing and issuing stock to fund growth expansions.

Newcomers to share market investing may be in for a surprise when they discover a stock’s share price does not always move in sync with financial results. What sometimes drives stock price movements is not whether the raw numbers are positive, but whether they meet expectations set by professional certified financial analysts and company management. The share price of a company that posted a loss may go up if the company lost less than expected. The stock price that posted a year over year revenue increase may go down if the revenues were lower than expected.

 

Key Points

• Twice a year ASX listed companies are required to release to the public financial and operational results for the full year or half year period of the fiscal year.
• Reporting includes an Income Statement, a Balance Sheet, and a Cash Flow Statement, all audited by an outside accounting firm.
• The numerical data included in these reports are used in calculating financial ratios used by a vast majority of investors to assist their stock picking.
• The financial statements and management commentary included in most provide context to financial ratios and should be seen as an integral part of evaluating stocks for potential purchase.
• The income statement tells investors its revenues, expenses, and net income.
• The balance sheet tells investors what a company owns and owes (assets and liabilities) and the net value attributable to shareholders.
• The cash flow statement tells investors how the company makes cash and where and how it spends cash from three sources – operating activities, investing activities, and financing activities.
• The determining factor in the market’s reaction to financial results sometimes depends on what results were expected to be, not what they were in reality.
• The balance sheet represents a single point in time – the close of business on the last day of the reporting period. The remaining statements cover the full or half year period in which the results were achieved.
• The three statements are interconnected with values from both the income and cash flow statements included in values appearing on the balance sheet.