How to Read an Earnings Report: Six Lines That Matter

What an earnings report is

An earnings report is the document a public company releases after each quarter to tell investors how the business did. In the United States it usually arrives as a press release, often with a slide deck and a conference call the same day, a few weeks after the quarter closes. The formal filing with the Securities and Exchange Commission, the 10-Q, follows later.

The release is written by the company, for the company's purposes. It tends to lead with the figures management is proudest of, and it often puts its own adjusted measures ahead of the standard ones. None of that makes it unreliable, but it does mean the order in which a reader takes in the numbers matters. A good habit is to skip the headline paragraph, go to the tables at the back, and read a fixed set of lines in the same order every quarter.

The other habit is comparison. A single quarter on its own says little. The useful question is what changed, and the cleanest comparison is with the same quarter a year earlier. Many businesses are seasonal: a retailer's holiday quarter, a heating company's winter, a software company's year-end deals. Comparing a December quarter with the September quarter before it mostly measures the calendar. Comparing it with the December quarter a year earlier measures the business.

The six lines in an earnings report

Take a made-up company, Harbor Tools, and its latest quarter set against the same quarter a year earlier.

1. Revenue. Sales rose from $2.20 billion to $2.40 billion, about 9 percent. Revenue comes first because every other line depends on it. Look for what drove the change: more units sold, higher prices, an acquisition, or currency movements, which a release usually breaks out. Growth that comes mostly from an acquisition or a weaker dollar says less about the underlying business than growth from selling more.

2. Margins. Gross margin rose from 38 to 40 percent and operating margin from 18 to 20 percent. Rising margins mean costs grew more slowly than sales, which is the sign of pricing power or of fixed costs being spread over more revenue. Falling margins on rising sales are worth a closer look: the company may be cutting prices to win volume, or its costs may be running ahead. The income statement guide walks through each line between revenue and profit.

3. Earnings per share. Diluted earnings per share rose from $0.73 to $0.93, about 27 percent, faster than revenue. Some of that came from the wider margins and some from the smaller share count in line six. Use the diluted figure, which counts the shares that options and convertible securities could add, rather than the basic one.

4. Cash flow. Operating cash flow rose from $470 million to $520 million. Profit and cash can drift apart within a quarter, because customers pay late, inventory builds or a tax bill falls due, so a single quarter's cash flow is noisy. The test over several quarters is whether cash keeps pace with profit. Many companies report cash flow for the year to date rather than for the quarter alone, so the quarter's figure sometimes has to be worked out by subtracting the previous report's. The cash flow statement guide explains the lines.

5. The company's own outlook. Many companies give guidance, a range for next quarter's or next year's revenue or earnings. It is management's forecast, not a fact, and it is worth reading for change rather than level: did the range move up, down or not at all since the last report, and did the wording around it become more or less confident? A company that stops giving guidance is telling you something too.

6. The share count. Diluted shares fell from 410 million to 400 million, so each share now claims a slightly larger slice of the profit. A falling count usually means share buybacks; a rising one usually means stock-based pay or shares issued for an acquisition. It is the line most readers skip, and it explains why earnings per share can grow faster or slower than the business itself.

GAAP versus adjusted figures in an earnings report

Most releases print two sets of profit figures. GAAP results follow US accounting standards and include every cost. Adjusted results, often called non-GAAP, leave out items management describes as unusual or not part of the ongoing business: restructuring charges, costs of an acquisition, the amortisation of intangible assets bought in one, and very often stock-based pay.

Suppose Harbor Tools also reports adjusted EPS of $1.01 against its GAAP $0.93, the difference being a restructuring charge. That adjustment may be fair if the charge really is a one-off. The question to ask is whether the excluded items recur. A company that has a "one-time" restructuring every year, or that leaves out stock-based pay that it hands to staff every quarter, is excluding real costs.

SEC rules require any company that publishes a non-GAAP figure to reconcile it with the closest GAAP measure and to present the GAAP figure with equal prominence. The reconciliation table, usually near the back of the release, lists every adjustment with its amount. Reading it is the fastest way to see what management is asking you to ignore. The accounting red flags guide covers the patterns that deserve more suspicion.

The earnings release versus the 10-Q

The release is fast and selective. The 10-Q, filed with the SEC within 40 or 45 days of the quarter's end depending on the company's size, is complete: the full income statement, balance sheet and cash flow statement, the notes that explain them, a management discussion of the results, and the risks the company sees. For the fourth quarter there is no 10-Q; the annual 10-K takes its place and arrives later still.

The two rarely disagree on the headline figures, but the filing carries what the release leaves out: the detail behind a change in receivables or inventory, a new lawsuit, a change in accounting policy, debt terms, segment results in full. A reader who wants to understand a quarter rather than just know its headline reads the 10-Q too. The quarterly reports guide covers the filing itself, and the SEC filings guide places it among the other forms a company files.

Where to go from here

An earnings report is easiest to read as a fixed routine: revenue, margins, earnings per share, cash flow, the company's outlook and the share count, each against the same quarter a year earlier, then the reconciliation between adjusted and GAAP figures, then the quarterly filing for anything that still needs explaining.

To practise on real companies, open Costco's quarterly earnings and Apple's quarterly earnings on the Earnings tab of each company's Tenet report, where each quarter's results sit beside its report date. The reading below shows one company's newest quarter, its earnings per share and revenue, with the date it was reported.