How to Understand Company Earnings Statements

Earnings, profits, revenue and cash flow typically flood the financial news on a quarterly basis, leaving some stock investors confused

Adam Zoll 5 March, 2014 | 7:00AM
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As earnings season draws to a close, some investors may be left scratching their heads at the variety of financial terms bandied about in news reports and company documents. If you're one of the many who has trouble keeping them all straight, here's your guide to some of the most important metrics that publicly-traded companies report at the end of their fiscal years and often in shorter statements throughout the year. Terminology used here is consistent with that used on Morningstar.co.uk's Equity Reports.

Turnover: Quite simply, this is the amount of money the company has brought in for goods and services provided over the given time period. Turnover growth (also referred to as revenue growth), in particular, is a statistic to watch because it may indicate whether the company's business is growing or declining.

Gross profit: The amount of company revenues left over after subtracting the cost of producing the goods and/or services it has sold. These include costs such as raw materials, salaries of the workers who make the products or deliver the services, and other production-related expenses.

Operating profit: The amount left over after subtracting the company's operating expenses from gross profit. Operating expenses include the cost of selling the company's goods and services, administrative costs and other costs of running the business, including depreciation of assets.

Net profit: The company's profit after all expenses are taken into account, including not only the cost of producing and selling the goods and running the business but also taxes, interest income and interest expenses. This is one of the most closely watched measures of a company's profitability and value to shareholders.

Earnings per share (EPS): The amount of the company's net profit divided by the number of shares of common stock outstanding. This is one of the most closely watched of all earnings numbers as it typically offers a good indication of the company's level of profitability. However, the number of shares outstanding may change over time due to company buybacks and splits, which can affect this number.

Diluted earnings per share: This is similar to the earnings-per-share calculation but factors in the potential effects of any outstanding convertible shares (preferred shares or bonds that can be converted to common shares), stock options and warrants.

Cash flow from operations: The amount of cash brought in by the company's operations before any investment or financing. This differs from net income in that it directly measures payments received by the company as opposed to factoring in depreciation, taxes and other accounting steps. Some people prefer this to net income as a measure of company profitability because it is less subject to company manipulation.

Free cash flow: Cash flow from operations minus capital spending, or expenses incurred to help grow the company. It represents the amount of excess cash flow that could be passed on to investors and is often taken as a sign that a company may be profitable beyond its need to invest in itself. However, free cash flow is a non-standardised accounting measure and can be calculated in various ways.

EBITDA: Abbreviation for "earnings before interest, taxes, depreciation and amortisation." This may be used as an alternative to net profit for companies with heavy depreciation charges. However, this metric also is not subject to standardised accounting rules, meaning it complements but does not serve as a substitute for net profit.

How These Statistics Are Used

To illustrate the role each of these financial statistics plays in reporting a company's performance, let's use an imaginary example we'll call XYZ Enterprises. Last year the company brought in a total of £100 million, which was its turnover (all numbers are purely for illustrative purposes and not meant to reflect the real world, so please hold your fire, accounting pros). However, its goods and services cost £60 million to produce, leaving it with a gross profit of £40 million. From that £40 million gross profit, take away the £25 million it cost XYZ to sell its goods and services, staff its headquarters and for other expenses related to running the business, and you get an operating income of £15 million. But after £5 million in taxes and interest payments are taken into account, you are left with £10 million, which represents the company's net profit.

The company has 20 million shares of common stock outstanding, making for earnings per share of 50 pence for the year. But if all its convertible shares, options and warrants were to be exercised, it would have a total of 22 million common shares outstanding, which makes its diluted earnings per share about 45 pence. The company's cash flow from operations is £12 million, but if you factor in capital spending designed to grow the business, it ends up with free cash flow of £10 million. Finally, if you were to look at its earnings prior to stripping out taxes paid, interest, depreciation and amortisation, you'd end up with an EBITDA of £20 million.

Areas of Focus

As stated above, earnings per share tends to be the key statistic for investors to pay attention to, not only because it indicates the company's level of profitability, but also because it indicates how that profitability corresponds to the number of shares of stock outstanding. Cash flow also tends to be closely watched as a way to gauge just how much money the company is bringing in without other accounting line items getting in the way.

In addition to the terms defined above, other terms may also be considered important for investors to know, especially for companies in specific industries. For example, same-store sales (sales from stores that have been open at least a year) tend to be a closely watched barometer of how a retailer is doing. Energy companies often report both upstream and downstream earnings to differentiate how their production (upstream) and delivery (downstream) operations are performing. And when evaluating a real estate investment trust (REIT), investors may pay special attention to funds from operations, which factors out the depreciation that can play havoc with the traditional net profit calculation and thus provides a truer measure of company performance.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Adam Zoll  is an assistant site editor with Morningstar.com, the sister site of Morningstar.co.uk.