Primer: Earnings Reports and Financial Statements

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If you have invested for a while, you should realize that publicly-traded companies are required to release earnings reports for each quarter, and for each fiscal year. These requirements are part of the Securities and Exchange Commission’s (SEC) assurance that public companies comply with their fiduciary responsibilities to communicate pertinent financial news and items with public investors.

What you may not know is what impact quarterly earnings reports have on stock price, and which key financial statements and metrics you need to evaluate. The following primer explains these details and more.

Earnings Reports: The Event

Most public companies must release quarterly earnings reports within 45 days of the end of a fiscal quarter. Following the completion of the fiscal 4th quarter and the fiscal year, companies have 90 days. Companies with smaller floats and those meeting certain exclusions based on conditional status (for instance newer public companies), are allowed more time. Companies may also request brief extensions and delay releases. They must file this request and give a reason for the delay. A commonly used and granted request is “More time for Auditor Review” or something similar.

Companies announce the date, time and format of their earnings reports anywhere from days to weeks in advance. The standard format includes a press release of key financial data, corporate announcements and commentary from executives. The PR is usually followed by a conference call with the CEO and other executives. During the call, executives present a prepared message to elaborate on financial data and activities. The calls normally conclude with questions from analysts. On occasion, companies hold “Town Hall” calls that enable retail investors to ask questions. Following the call, transcripts and recordings are available through various online channels, including the company website.

Here is an example of an “Earnings Calendar” available through Yahoo! Finance. Most brokers and investment websites offer earnings calendars and alerts. This information simplifies your ability to apply earnings-specific trading strategies or simply to track earnings on the company’s you own or watch.

After public communication of earnings information, companies file required documents with the SEC. A 10-Q is filed for quarterly earnings and a 10-K is filed for annual earnings. The 8-K report is another common filing investors see, which is filed to communicated pertinent events or news that the SEC requires companies to disclose in a timely manner.

Trading Strategy Around Earnings Reports

Investors and traders employ a number of strategies before, during and after earnings events. Some traders prefer to refrain from a position until after earnings have been reported and they have time to assess the results.

Here are a couple other common strategies and considerations:

Pre-Earnings Trading: Theoretically, earnings information is confidential until reported. Of course, there is some belief that earnings details are “leaked” or become known by funds or larger entities that follow companies. If sentiment heading into earnings is strong, it is likely the stock price appreciates the days or weeks heading into earnings. A common rule of investing is “buy the rumor, sell the news.” In other words, price is affected by anticipation of the event. In contrast, negative perceptions can cause share-price declines before earnings. Traders may opt to buy, sell or short depending on the vibe they pick up. Given the more speculative nature of this strategy, traders may take profits ahead of earnings to avoid the risk of an earnings surprise.

Immediate Post-Earnings Trading: Companies can release earnings reports at any time on any day of the week. However, most release their reports after normal market hours. Many others release them before normal market hours. There are some companies that routinely or occasionally release reports during normal market hours. Given the relatively thin trading environment during pre-market and after-hours sessions, it is common to see price volatility immediately after earnings releases and during earnings calls. Again, some traders prefer to let the dust settle to avoid the volatility. Others like the speculative risk-reward. Just know that large funds drive the action, and emotionally buying or selling into the momentum is usually a losing game for retail traders. If you do not get a good price, do not buy/short.

Earnings Report Factors that Influence Stock Price

The aftermath of an earnings report is fueled by the comparison of actual results to expectations. Analysts and investment sites project key financial data and expectations for the period. If actual results are largely in line with projections, post-earnings volatility is likely less volatile. In the event of a positive or negative earnings surprise, volatility normally ensues as market makers and traders move quickly to adjust. Because of emotional buying or panic selling, the adjustment to actual results often exceeds a realistic response relative to what occurred in the stock in anticipation of the results. Savvy investors often wait for the emotional wave of buying or selling to unfold before finding an ideal entry before the dust settles and the emotions unwind.

In addition to financial data, company news announcements, events and activities, along with the general sentiment of executives during the call, impact the reaction to earnings reports.

Corporate Financial Statements

There are four common financial statements that public companies (and many private companies) prepare (and have audited) for each reporting period.

Here are the four statements and a brief synopsis of what they include:

Balance Sheet

Provides an overall assessment of the company’s current financial position. It follows the accounting formula that Assets = Liabilities + Owners’ Equity. Assets are the tangible property and intellectual properties a company owns that it could convert into cash. Current assets (such as cash and equivalents) are assets that are most efficiently converted to cash. Liabilities are debts or financial obligations, including short-term (generally 12 months or less) and long-term (longer than 12 months). Owners’ equity is the accounting value of the ownership (public/investors) in the company. It is what remains after you consider the worth of your assets minus liabilities.

Here is an example of annual balance sheet breakdown from Yahoo! Finance. You can access company financial statements from many online financial sites, including historical records. You can see the threaded breakdown on the left where you can go from general account overview to more detailed elements within the key sections. You can switch to quarterly to see the four most recent quarters (YF offers more historical records by subscription).

Income Statement

As the label suggests, a company’s income statement shows its net income or profit (or loss) for a given period. It includes three levels of income analysis. It starts with top-line revenue (sales dollars generated during the period). Gross income is initially calculated by subtracting costs of goods sold (COGS or variable costs) from sales. Gross income is then reduced by accounting for operating expenses (fixed costs) during the period. These are costs incurred from normal business operations regardless of sales/unit production. Asset depreciation, amortization, and income taxes are included as operating expenses. Finally, any extraordinary revenue and/or expenses are accounted for to derive net income, or “bottom-line” profit. Extraordinary items include such things as asset sales, one-time write-offs and one-time acquisitions or fees.

Income statement example.

Cash Flow Statement

The cash flow statement shows how the company’s cash position has changed from the previous period to the current period. A net positive cash flow means the company is in a better cash position than it was before. A net negative cash flow means the company’s cash position has been reduced. Revenue and expenses naturally affect cash flow. However, cash flow can often tell a very different story than the income statement depending on factors such as depreciation, amortization and relative activity in accounts receivables (what you are owed on accounts) versus accounts payables (what you owe on accounts).

Cash flow statement example.

Statement of Owners’ Equity

The statement of owners’ equity magnifies what is included within the balance sheet. It shows the change in equity from the previous period to the current one. It includes current and previous outstanding share counts. It also shows retained earnings (profit that the company has accumulated over time) or accumulated deficit (the amount of losses the company has accumulated over time).

Financial Data that Influences Share Price

There are a lot of financial metrics that collectively tell the story of a company’s current financial situation and its potential for improvement or regression in that position moving forward. The key metrics that influence share price, and the ones closely watched by large banks and analysts, are not necessarily the ones a lot of retail traders give the most attention. In general, share price appreciates based on anticipation of growth and/or positive future events, and it goes down in anticipation of stalled or regressed growth trends and/or negative future events.

There are other factors to consider, but here are some of the most critical data points to watch for in an earnings report:

Cash Flow: “Cash is king.” You may have heard this familiar adage but not necessarily considered its meaning. In business, cash is stability. It’s freedom. It’s control. Companies that have a strong cash position are not at immediate risk of bankruptcy, and should be able to cover near-to-medium term payables and debt obligations. These financial assurances are job one. Beyond that, positive cash flow gives the company opportunity to reinvest in growth. It can use the extra cash to hire more people, improve technology, develop better products, acquire companies or assets, and much more. Amazon is a quintessential example of this mantra. The company famously went many years without turning a profit. However, the share price continued to escalate during this time primarily based on a constantly improving cash position that enabled its rapid growth.

Revenue Growth and Growth Potential: Focus on sales growth is intertwined with cash flow. Share price typically reacts more to reported or anticipated improvement in revenue than it does profits. This reality is fueled by the aforementioned rule of thumb that price moves in anticipation and reacts to results. The expectation is that if sales increase and cash flow grows, profitability or profits will follow. Watch for reported percentage changes in revenue relative to what analysts had forecasted. Better-than-expected revenue growth is a common catalyst for a post-earnings bounce.

Gross Margin Change: Gross margin is the rate at which a company converts sales into gross profits. A high gross margin means the company efficiently turned sales into gross income (and likely cash flow). Efficient gross profit optimizes your ability to cover operating expenses and other extraordinary expenses to arrive at net income or a reduced net loss. You can easily calculate gross margin by dividing a company’s gross profit into its revenue. For instance, a gross profit of $1m on $2m in revenue equals a 50% gross margin or gross profit (income) margin. Companyies and analysts often do the work for you, though, and communicate gross margin for the period. Whether the company’s margin is good, bad or in-between depends on the industry and company history. Gross margins that exceed industry norms and/or that are improved from one period to the next are considered positive. The opposite is true if a company’s margins are relatively low or decreasing.

Profit Growth: Profit does matter, although it is not at the top of the list in most cases. However, profit growth or information that leads to anticipated profit growth is what impacts price. It is not uncommon that a company reports millions or even billions of dollars in profit, but the share price holds steady or declines after earnings. This occurrence is based on declining profit from the previous period, profit that was short of analyst projections, profit that is generated by limited occurrence business activities and/or profit that is expected to stall or decline in future periods.

Earnings Per Share: The amount of income divided by the number of outstanding shares. EPS is a metric of profit efficiency in that it shows how much profit the company generates for each share of ownership. Again, better-than-expected results or improving results from one period to the next are keys to positive share-price influence. As with profits, a negative EPS (resulting from a periodic net loss) may still boost share price if it is improving or better than analysts forecasted.

Conclusions and Recommendations

Take time to learn about the timing and format of public-company earnings and key financial statements, and how they influence share price before, during and after their release. If you do not understand these reports, you allow varied analyst and media interpretations, and what other traders tell you on message boards, to be your due diligence. In other words, you are gambling on your ability to trust what you see, hear and read more than your own ability to assess what you know and see.

If you are inexperienced, you may feel like this is your reality. However, especially in penny stocks, this is a bad reality. A lot of earnings content is produced by people with even less experience than you, and even worse, it is sometimes produced and delivered by entities that leverage the message for their own financial interests. As you might have heard, or read on a message board, “do your own due diligence.”

Do you have other earnings items or financial metrics you track, or that you think are important? Post a comment and let us know!

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