Finance 101: An Earnings Season Primer

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Charles Schwab & Co., Inc.

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Finance 101: An Earnings Season Primer

When stock markets boomed in the 1920s, investors had to fly blind deciding which companies were sound investments—most businesses had no legal obligation to reveal their performance. After the 1929 market crash, however, reforms enacted to help prevent a repeat disaster required publicly traded companies to regularly disclose certain details about their operations.

The financial statements required in these filings—the income statement, balance sheet and statement of cash flows—are important tools used to analyze companies, providing a quick picture of a company’s financial health and its value.

Income statement
The income statement makes public the results of a company’s business operations for a particular quarter or year. Through the income statement, you can witness the inflow of new assets into a business and measure the consumption of assets that result from the production of revenue. Profitability is measured by revenues (what a company is paid for the goods or services it provides) less expenses (all the costs incurred to run the company) and taxes.

The income statement is read from top to bottom, starting with revenues collected. Expenses and costs are subtracted, followed by taxes. The end result is the “bottom line”: a company’s net income, or profit, before paying any dividends.

Income statement for YYZ Corp.* for the year ending Dec. 31, 2002 (in millions)
Revenues	2002	2003
Sales	$350	$270
Cost of goods sold	(250)	(190)
Cell 4:1
Gross profit	100	80
Depreciation expense	(10)	(10)
Taxes on income	(15)	(20)
Net income	$75	$50
Cell 9:1
Average common shares outstanding (in millions)	25	25
Cell 11:1
Earnings per share (EPS)	$3.0	$2.0
Cell 13:1
Dividends declared per common share	$.050	$.045

* YYZ Corp. is a hypothetical example used for illustrative purposes only

The next line indicates the average number of common shares of the company’s stock actually held by investors. Then you find the firm’s earnings per share: net income divided by the number of shares outstanding.

Finally, the last line shows the dividends declared per common share, or the cash payment per share the company makes to stockholders. The payment and amount of dividends are at the discretion of the company’s board of directors.

Consolidated balance sheet
Whereas the income statement is a record of a company’s revenue stream over a given time period, the balance sheet is a snapshot of a company’s financial position at a given point in time—what a company owns (assets) and owes (liabilities) and the difference between the two (stockholders' equity), which is the book value of the stockholders’ stake in the company. It’s called a balance sheet because both sides of the equation have to be balanced: Assets = liabilities + stockholders’ equity.

The balance sheet lists assets held by the company and what portion of those assets is financed (liability) or equity (retained earnings and stock). Generally, assets are listed from most to least liquid (i.e., assets that can be most quickly converted to cash are listed first) and liabilities in order of immediacy (i.e., those that have the most senior claim on a firm’s assets are listed first).

Balance Sheet for YYZ Corp.* for the year ending Dec. 31, 2002 (in millions)
Assets		Liabilities and owners' equity
Cell 3:1
Current assets		Current liabilities
Cash	$92	Accounts payable	$30
Accounts receivable	50	Short-term debt	20
Inventory	30
Total current assets	172	Total current liabilities	50
Cell 8:1
Long-term assets		Long-term liabilities
Equipment	230	Long-term debt	200
Buildings	90
Total long-term assets	320
Cell 13:1
		Owners' equity
		Stock	2
		Additional paid-in capital	148
		Retained earnings	92
		Total shareholders' equity	242
Cell 19:1
Total assets	$492	Total liabilities and owners' equity	$492

* YYZ Corp. is a hypothetical example used for illustrative purposes only

The amount by which assets exceed liabilities is listed as stockholders’ equity—the net worth of a company, or the book value of the stockholders’ stake in the firm. Stockholders’ equity includes common stock, additional paid-in capital, and retained earnings.

Cash flow statement
Like the income statement, the statement of cash flows reflects activity over a period of time. It shows where a company has cash comes from and how it’s used to pay for operations or to invest in the future. By showing how a company’s managed the inflow and outflow of cash, the statement of cash flows paints a better picture of a company’s liquidity (the ability to pay bills and creditors and fund future growth) than the income statement or balance sheet.

Statement of cash flows for YYZ Corp.* for the year ending Dec. 31, 2002 (in millions)
From operations
Net income	$30
Plus depreciation	15
Plus decrease in receivables (less increase)	(20)
Less increase in inventories	(10)
Plus increase in accounts payable (less decrease)	0
Net increase (decrease) in cash from operations	15
Cell 8:1
From investing
Less purchase of equipment	(150)
Cell 11:1	Cell 11:2
From financing
Bonds issued	100
Net increase (decrease) in cash	(35)
Cash at beginning of year	127
Cell 16:1
Cash at end of year	$92

* YYZ Corp. is a hypothetical example used for illustrative purposes only

Cash flow from operations
Cash flow from operations starts with net income and adjusts out all non-cash items. Income and expenses on the income statement are recorded when a company earns revenue or incurs expenses, not necessarily when cash is received or paid. To figure out how much cash a company received or spent, net income is adjusted for any sales or expenditures made on credit and not yet paid with cash.

Cash flow from investing and financing
Cash flow from investing includes cash received from or used for investing activities, such as buying stock in other companies or purchasing additional property or equipment. Cash flow from financing activities includes cash received from borrowing money or issuing stock and cash spent to repay loans.

Sizing up operating performance
Of the main sources of cash flow, analysts look to that from operations as the most important measure of performance. Also, a decrease in cash flow due to a sharp increase in inventory or receivables can signal that a company's having trouble selling products or collecting money from customers.

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