What to look for: Quality

Important attributes to look for in an earnings statement - QUALITY

As the market exerts ever-increasing pressure on companies to perform to a stringent set of expectations, the idea of accounting "stretch" enters the picture.

Even in complying with the rules, companies have latitude to apply accounting principles in ways that make performance look better.

This lattitude can affect the quality of earnings reports.

Recent legislation and standardizations like the Sarbanes-Oxley Act, have brought financial reporting generally more in line with reality.

What to look for: Healthy Components in the Earnings Statement

Important attributes to look for in an earnings statement - HEALTY COMPONENTS: COMPARATIVE and TRENDS

Value investors look at individual lines in the earnings statement, not just the bottom line.

Improving gross margins - especially sustained improvement - signal strong business improvement.

Costs are under control, and the company is improving its market position.

Likewise, improving operating margins can show better cost control, greater efficiency, and rewards from earlier expansion cycles.

And value investors constantly compare companies in similar industries.

Gross margins of competing computer manufacturers, for instance, tell a lot about who has the

• best market position,
• production and delivery process, and
• business model.

Comparing the incomparable is an all-too-common investing pitfall. With earnings statements, this error takes three forms:

1. Earnings statements are not always broken down the same way.

• Although the bottom line is the bottom line, the intermediate steps may be different.
• One company's operating earnings may include marketing costs, while another's may not.
• Typically, statements from firms in the same industry are comparable, but not always.

2. Two companies that appear (and even are classified) in the same industry may have differences large enough to raise caution.

• Commercial and industrial suppliers, such as Honeywell, have consumer divisions, while consumer businesses, such as Procter & Gamble, have industrial divisions.
• Many businesses supply a mix of products in a mix of categories to a mix of customers.
• "Pure plays" in a business or industry are not always easy to find.
• The upshot: You must understand businesses before comparing them.

3. Numbers may include extraordinary items.

• Before comparing operating or net profit numbers, consider whether there have been write-offs for discontinued businesses or impaired assets that may be causing one-time distortions in the numbers.

What to look for: Consistency

Important attributes to look for in an earnings statement - CONSISTENCY

Long-term growth should be sustainable and consistent.

Look for sustained growth across business cycles.

A big pop in earnings one year followed by malaise for the next two does not paint a pretty picture. Long, consistent successful earnings track records get the A grades.

Beyond earnings, consistency is a desired feature for other parts of the earnings statement.

Consistency is highly prized in:

• sales and sales growth,
• profit margins and margin growth, and
• operating expense and expense trends.

The less consistency, the more difficult to predict the future five or ten years and beyond, and the less attractive a company looks to value investors.

What to look for: Growth

Important attributes to look for in an earnings statement - GROWTH

After all is said and done, the long-term growth of a stock price is driven by growth in the business.

Growth in the business means growth in the earnings - there is no other way to sustain business growth without infusions of additional owner capital.

Sure, you can acquire, merge, or sell more stocks to make a business larger by common definitions, but has the business really "grown"?

The value investor works to obtain a deep understanding of business growth, growth trends, and the quality of growth.

• Is reported growth based on internal core competencies?
• Or is it acquired or speculative growth based on unproven ventures?

The value investor assesses growth and growth patterns, judges the validity of growth reported, and attempts to project the future.

A business' ability to grow on its own, through its own success and resulting earnings, is known as organic growth.

Growth through acquisition or other capital infusions are not "organic" and thus does not suggest growth in true business value.

The Importance of Earnings

Business and economic activity are undertaken with the idea of generating a profit.

Profit is simply the gross revenue of an enterprise, minus the cost of producing that income, over a defined period of time. For businesses, it's important to measure the profit and allocate capital resources in such a way as to maximise it.

It is the earnings that make the world go round.

So much is made of earnings and earnings reports. Do you hear much about a company's cash balance, accumulated depreciation, or owner's equity during CNBC and other financial shows?

Does everyone salivate four times a year for "asset season?"

No, but there's a definite "earnings season" at the end of each calendar quarter, giving financial analysts, journalists, and pundits plenty to talk about.

On an ongoing basis, earnings are the driving force and "macro" indicator of a company's success.

• If earnings are growing, the financial press doesn't worry much about the other stuff.
• Conversely, serve up a couple of double faults on the earnings front, and everybody is all over asset impairment, write-offs, debt, weak cash positions, and the other similar "disasters."

In the purest sense, long-term stock price appreciation is based on the growth of a company's asset base and owner's equity in that base. Ultimately, that comes from earnings.

If a company is earning money, and particularly if it earns it at a growing rate, that's a good thing. As Warren Buffett says, "If the business does well, the stock always follows."

Earnings tell us how well a business manages its operations, while the balance sheet tells us how well it manages its resources.

Stick to what you need to know as an investor, avoiding deep accounting technicalities

Just as life cannot be measured or evaluated by a single snapshot, neither can a business.

Balance sheet gives a snapshot view of business resources (assets) and how they are contributed to the business (liabilities and owner's equity). Comparison of one snapshot to another tells you something changed. But what happened between shots, and why?

This is where earnings and cash flow statements come in. The balance sheet is critical in evaluating the financial state of a business; the income and cash flow statements together measure business activity and results.

Earnings and cash flow statements show the pulse of the business and explain changes in balance sheet snapshots. With these statements, the business analyst or investor can assemble a complete moving picture showing flows into and out of the business, successes and failures, growth and decline.

You need to stick to what you need to know as an investor, avoiding deep accounting technicalities.

Bottom lines and other lines

Revenue
less COGS
-----------
Gross Profit
less Operating Expenses
-SGA
-R&D
-Depreciation & Amortization
-Impairment, Investments & Write Downs
-Goodwill amortization
-----------
less or add interest
-----------
PBT
less tax
-----------
Operating Income or Income from continuing operations
less or add extraordinaries
-----------
Net Income



The bottom line, refers to the net earnings or income after all expenses, taxes, and extraordinary items are factored in. The bottom line is the final "net" measure of all business activity.

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Gross profit:

This is simply the sales less the direct cost of producing the company's product or service.

Direct cost includes:

• labor,
• material, and
• expenses directly attributable to producing it.

Gross profit, often called gross margin, is the purest indicator of business productivity, because each cost dollar is directly generated by production and sale of the product.

Value investors closely watch gross margin trends as an indicator of market dominance, price control, and future profitability.

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Operating Income:

This term refers to gross profit less period expenses, such as overhead or marketing costs not directly attributable to product production.

Selling, general, and administrative expenses (SG&A) usually cover all headquarters functions, information technology, marketing, and other indirect costs.

It generally includes financing costs, such as interest, and taxes.

Amortization is usually included, because cost recovery for property, plant and equipment is part of operating expense.

Items deemed extraordinary are not included.

Operating profit gives a more complete picture of how the business is performing on a day-to-day basis.

It sometimes appears as operating income, earnings from operations, or something similar.

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Net Income:

This represents the net result of all revenues, expenses, interest, and taxes.

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There are other supplemental earnings measures, such as free cash flow and "EBITDA."

The point is that there are many ways to measure income.

Each reveals an important layer of business performance, both for determining intrinsic value and also for comparing companies.

Cash Flow from Financing Activities

Investing activities tell what a firm does with cash to increase or decrease fixed assets and assets not directly related to operations.

Financing activities tell where a firm has obtained capital in the form of cash to fund the business.

Source of cash for financing: Proceeds from the:

• sale of company shares or
• sale of bonds (long-term debt).

Use of cash for financing: If a company:

• pays off a bond issue,
• pays a dividend, or
• buys back its own stock.

A consistent cash flow from financing activities indicates excessive dependence on credit or equity markets. Typically, this figure oscillates between negative and positive.

A big positive spike reflects a big bond issue or stock sale. In such a case, check to see whether the resulting cash is used:

• for investments in the business (probably okay) or
• to make up for a shortfall in operating cash flow (probably not okay), or,
• if the generated cash flows straight to the cash balance, you should wonder why a company is selling shares or debt just to increase cash, although often the reasons are difficult to know. Perhaps an acquisition?
  

An illustration:

Company X's statement shows a happy story for investors:

• $15.4 m paid to investors as dividends
• $8.2 m paid out in "Sale Purchase of Stock" (- this is most likely for a share buyback. In fact, the company X actually repurchased $17.2 million in its own stock on the market; then issued $8.9 million in stock, most likely for employee stock options ESOS, and compensation.)

Still, this isn't bad - shareholders benefited from both the dividend and the repurchase.

Bottom line: Company X is using surplus cash generated from operations to give something back to shareholders. That's a good thing.

Free Cash Flow

Free cash flow is a good indication of what a company really has left over after meeting obligations, and thus could theoretically return to shareholders.

Free cash flow is sometimes called "owners' earnings."

Free cash flow is defined as net after tax-earnings, plus depreciation and amortization and other noncash items, less annual capital expenditures, less (or plus) changes in working capital (current assets and liabilities).

It is surplus cash that is really free, not waiting for a bill to come for a big capital purchase or inventory increase.

Earn income, pay for costs of doing business, and what's left over is yours to keep as an owner.

Free cash flow is a much more realistic long-term view of business success and potential owner proceeds than EBITDA and is used by many value investors as the basis for calculating intrinsic value.

Cash Flow from Investing Activities

Cash flow from operations tells what cash was generated in the normal course of business and by changes in current asset and liability (working capital) accounts on the balance sheet.

• But what about cash used to invest in the business?
• Invest in other businesses?
• What about cash acquired by selling investments in other businesses?

The statement of cash flow from investing activities provides this information.

This section shows, among other things: cash used for investments in the business, including

• capital expenditures for plant, equipment, and
• other longer-term product assets.

For most growing companies, while cash flow from operations should be positive, cash flow from investing activities is often negative.

Why? Because growing companies need more physical investments - property, plant, and equipment (PP&E) - to sustain growth.

It is possible to generate positive cash flows in this part of the statement either

• by selling PP&E or
• by selling investments owned by the company.

More often than not, the total "Cash Flows from Investing Activities" is negative, and that is perfectly normal.

TIP: By comparing net cash flows from operations and net cash flows from investing activities, you can get a first glance at whether a business is productive and healthy.

If positive CFO > negative CFI, then the business produces more cash than it consumes.

But don't jump to a favourable conclusion too quickly - you may be looking at an airline (e.g. Air Asia ?) that's about to pay for five new jets in the next quarter. A surplus cash situation must be sustained to be meaningful.

How changes in Working Capital affect Cash

How changes in Current Liabilities affect cash

Increase in accounts payable (a bigger liability) generates cash.

• Suppose the company you're watching has a $45 million increase in cash from accounts payable.
• There is $45 million in cash floating around in the business that didn't show up in net income.
• Let's suppose that one large item was purchased for $45 million. An accounting expense was incurred when the payable was created, but no cash has yet been used to pay the bill. It's still in the bank.
• So while the expense was incurred, reducing earnings, the cash wasn't paid and, at least for now, there's more cash in the business.

Increase in current liabilities provide cash.

Decrease in current liabilities use cash.

How changes in Current Assets affect cash

In different financial statements, it is common to see account receivable, inventories and accounts payables either providing or using cash.

Increases in current assets (other than cash) use cash.

Decreases in current assets (as in a net decrease in inventory) provide cash.

Cash Flow from Operations

Net Income
----------
Operating Activities, Cash Flows Provided By or Used In:

Depreciation
Adjustment to Net Income
Changes in Accounts Receivable
Changes in Liabilities
Changes in Inventories
Changes in Other Operation Activities
----------
Total Cash Flow from Operating Activities



Cash flow from operations, CFO, tells what cash is generated from, or provided by, normal business operations, and what cash is consumed, or used in the business.

Net income from continuing operations is the starting point, to which cash adjustments are made.

To that figure, add (or subtract) what was called the "adjustments to reconcile net income to net cash provided by operating activities."

The first adjustment item is depreciation.

• For example, depreciation in Company X was $24 million. So, we known that without other adjustments, $24 millionn more in cash was generated than reported as net income, because depreciation was subtracted from net income, but not from cash flow because it isn't a cash expense.

Then a catch-all "Adjustments to Net Income" category.

After this, comes:

• "Changes In Accounts Receivables"
• "Changes in Liabilities"
• "Changes in Inventories"

Finally, you arrive at a total "Total Cash Flow from Operating Activities," derived by netting the adjustments to toal income.

• This is a very important figure. Essentially, this is cash generated by ongoing day-t0-day business activities.
• If this amount is negative, that's bad, because it means that the business isn't even supporting itself on a day-to-day basis and requires an infusion of cash.
• If it's positive - we're still not out of the woods yet - capital investments may still require more cash than the business is producing.

A bit of EBITDA

EBITDA measures operating cash generated before:

• non-operating interest,
• taxes, and,
• noncash depreciation & amortization.

In a sense, EBITDA is operating income before:

• bankers (non-operating interest), and
• government (taxes), and
• accountants (noncash depreciation & amortization).

EBITDA is also sometimes looked at as a liquidity measure:

• Positive-EBITDA companies can service their debt, while
• Negative-EBITDA companies must borrow more.

Beware of glowing announcements of positive EBITDA, especially when accompanied by losses on the earnings statement.

Income from continuing operations versus EBITDA

Revenue
less COGS
-----------
Gross Profit
less Operating Expenses
-SGA
-R&D
-Depreciation & Amortization
-Impairment, Investments & Write Downs
-Goodwill amortization
-----------
less or add interest
-----------
PBT
less tax
-----------
Operating Income or Income from continuing operations
less or add extraordinaries
-----------
Net Income


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EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization

EBITDA measures operating cash generated before:

• non-operating interest,
• taxes and
• noncash depreciation and amortization.

Income from Continuing Operations

Operating income is simply sales less cost of goods sold, less operating expenses.


Because it includes noncash amortizations, it is a "fully loaded" view of operating performance in the business. (Depreciation and amortization expenses are usually broken out on the earnings statement, but may also be buried in a consolidated SG&A, or other operating expense line.)


If you closely observe the effects of amortizations, special write-downs, and accounting changes, you can better understand operating income and operating income trends.



Income from continuing operations tell shareholders, in total, what their investment is returning, after everyone, including Uncle Sam and his brethren, is paid.


Income from continuing operations is a good indicator of total business performance, but be aware of truly extraordinary events driving expenses or income.