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If you’ve ever been trying to get back on track financially, you’ve probably encountered the concept of a budget. Before I got married, my husband and I made sure we were on the same page financially with a budget to avoid any unnecessary arguments.
We went through all of our set expenses as a couple, as well as any other variable expenses we could foresee spending on, like clothing and groceries.
We also noted our income sources, and added those up to make sure we weren’t spending more than we were making. Then, each month I went in and updated our budget to see if we were on track to spend within each category’s limit.
You can look back and see months of this tracking in a google sheet we share… It’s quite a lot of information!
Did you know that most companies do the same thing, just on a much larger scale? Every expense and income is documented and pulled together quarter by quarter for every public company.
It takes much more than just a 30 minute update every week, and many financial professionals track these dollars to make sure the company continues to be financially successful.
When it's all put together and ready to be viewed, it's filed with the SEC (the IRS of the stock market) as a 10-Q, also known as an Earnings Report.
These are the secret weapons of investing, and they give you the inside scoop before you go ahead and buy their stock.
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What is an Earnings Report?
So, let’s back up a little. We touched on the fact that an earnings report is kind of like a budget, but allegories aside, what exactly is it?
Essentially, it’s a way for companies that are traded publicly (meaning their stock is traded on the stock market) to keep transparency with investors. It means that you, as an investor, have a better chance at making an informed decision when you purchase stock in a company.
Like I mentioned earlier, it’s also known as an earnings statement, or a “Form 10-Q” that’s filed with the SEC.
When a company files this form, they typically also issue a press release highlighting the main points of the report, and how the company seems to be doing as a whole.
However, I wouldn't take the company’s word for how they’re doing. Like all of us, companies want to portray their best self to the public, causing room for exaggeration or over-optimism within their press release.
Currently, a company called Live Ventures is undergoing a lawsuit for misleading reports in their earnings statement press release. This is why it’s so important to check out the actual earnings report, instead of going by hearsay or press releases that might seem a bit easier to understand.
Plus, you’ll be surprised with how easy it is to decode an earnings statement once you learn the ropes!
First of all, an earnings report will include 3 main components. These are:
1. Income Statement
This statement is key for investors to take a look at. It will show the company’s expenses and income during the quarter they are reporting for.
2. Balance Sheet
This part of the earnings statement reports 3 items:
- A company’s assets
Assets include the value of any properties, cash on hand, and current inventory. They are a very positive part of the balance sheet!
- A company’s liabilities
Liabilities include any debt or unpaid bills that the company currently holds. This line item is more negative, but might be necessary for the company to keep operating.
- A company’s equity
The equity is the sum of the assets minus the liabilities! It’s that simple. The company’s total equity is an item to definitely check out on the earnings report.
3. Cash Flow Statement
Think of the cash flow statement as a comprehensive total of all the cash that goes in or out of the company! Check out the cost of sales, which is any costs related to the direct business the company does.
This part of the earnings report will also include any disclosures or extra information like current lawsuits investors might want to check out.
Why Do I Need to Look Up an Earnings Report?
You might be wondering why on earth you need to go through the trouble to decode the earnings statement and get into the nitty gritty of how the company you’re looking at is doing. One key component to investing is knowledge.
Armed with the knowledge you need about a company, you can decide if it’s worth your money to invest in it. Just going off of hearsay and friends’ preferences can lead you down an unsuccessful road you don’t want to go down.
It was so crucial for me to have the confidence I needed before I bought shares of stock in certain companies.
The internal workings of a company are extremely closely related to the stock prices. If you never take a look at the financial status of the company, you’ll never know if you made a wise investment or not. Doing your research is an essential part of smart investing.
Let’s talk more about what to look for and how these red flags and green lights affect the pricing of a stock.
What Am I Looking For in an Earnings Report?
Here are several options of red flags, or green lights that you might see while perusing an earnings report. I’ve seen all of these with 10-Qs I’ve looked at!
If you notice at the end of the cash flow statement that the company has disclosed that they’re involved in a lawsuit, this can be a red flag.
Check out the lawsuit and its estimated costs, and decide if you think it would be a major setback for the company, or a minor issue.
One of the best things you can do for yourself is to look at not one earnings report, but two or more! When I’m researching a company I want to invest in, I check out their most current earnings statements as well as a few that were from the past year or so.
Then, I compare. I look at things like equity and income from the income statement and balance sheet that show me if the company’s success has continued, or if they are doing worse than before. I also check out their liabilities and see if they’ve taken on more debt.
If the company is growing in income, they might need to take on more debt to cover new operational expenses, but if they aren’t making more income, this can be a red flag.
Cost of Sales
Like I mentioned earlier, cost of sales (or COGS, cost of goods sold) includes expenses directly related to the company’s specific business. Just like the liabilities section, you’ll want to see if the COGS is growing in proportion with the company’s income.
This would be a green light! However, if the company is spending more and making less, you might rethink investing in their stock.
How Do These Things Affect the Stock?
Now that we’ve touched on the different parts of the earnings statement and how to decode it, why does it matter? Will these details really affect the success of your investment? I have found that the answer to this question is: absolutely.
Because of the need for transparency for a publicly traded company, we have the details of their finances at our fingertips. The telltale signs of a negative or positive future for a company lie within the earnings report!
Say you invest in a company that is slowly taking on more debt and making less income. Over the next few months or years, it’s likely that investors will stop trusting the company’s success and sell their shares, lowering the price of the company’s stock, and therefore causing you to lose money on your investment.
The Bottom Line
Do you see how the inner workings of the company are so directly related to the stock prices?
You probably wouldn’t lend money to a friend if you could see that their budget wasn’t setting them up for success. They wouldn’t be able to pay you back like you hoped… Don’t you feel the same way about giving your money to a large company?
I definitely felt like I had tapped into a super power when I gained the ability to understand an earnings report. I hope you feel the same way!