To make the most informed decisions, investors should understand how to review an income statement.
Trying to decipher a profit-and-loss statement is complicated.
"It's like an online dating profile," says Ross Gerber, the CEO of Gerber Kawasaki Wealth Management, a registered investment advisor based in Santa Monica, California. "It's a person's version of who they report to be. What a company does with its P&L depends on the company. Some are honest and some are very manipulative because a lot of accounting rules are esoteric."
Understanding, even at a high level, how to read an income statement – sometimes called an earnings statement – can help investors make more informed decisions.
"These financial statements are some of the hardest documents on earth for people to understand, even for accountants," says Steven L. Wilson, a registered representative of HD Vest Financial Services and founder of Steven L. Wilson and Associates in Tulsa, Oklahoma.
Although all experts suggest going to a financial professional who has the background and industry knowledge on how to read such documents, it's important to know what to look at when an earnings statement is released quarterly or annually to the U.S. Securities and Exchange Commission.
Start by going directly to the company's website, Gerber suggests. Search for presentations for institutional investors, which may be listed under an investor relations tab. Review quarterly 10-Q and annual 10-K reports.
Look for growth. "If earnings and revenue isn't going up, your stock isn't going up," Gerber says. "There is a direct correlation between a stock price appreciation and profit growth."
While companies may have a down quarter or year, it shouldn't happen on a year-over-year basis.
Know what to compare. Looking at profit margins on a quarterly basis is one of the biggest mistakes an investor can make, Gerber says. Instead compare year-over-year profit margins to have a true comparison.
For example, Under Armor (ticker: UA) has recently struggled after Sports Authority went out of business and it had to look for a new retailer in Kohl's Corp. (KSS), Gerber says, but that is for the short term, which is why quarter-to-quarter comparisons can be misleading.
Other important tips. Income statements are divided into operating expenses, with recurring business revenues and expenses, and non-operating expenses. The latter includes non-recurring expenses and revenues not related to its day-to-day operations, such as depreciation, amortization – the spreading of payments and costs over time – interest charges, the cost of borrowing or sale of investments.
Compare a company's revenue, which includes the raw material costs of goods being sold, how much is being paid for components after revenue, the expenses and net profit margin.
Look at the operating profit margin, Gerber says, which is how much profit a company makes before interest and taxes to see how much value is being created for shareholders and its net profit.
"That's not as important as the gross profit, because companies have a lot of depreciation they write off for tax purposes," says Gerber, since gross profit reflects the total revenue minus the cost of goods sold, but doesn't include operating expenses, interest payments or taxes.
Review the EBITDA. "Earnings before interest, taxes, depreciation and amortization, is a fancy way of saying cash flow," Gerber says.
Think of it as the revenue minus the cost of producing goods or a service and the general operating expenses that can affect the income statement, says Eric Meermann, a certified financial planner at Palisades Hudson Financial Group in Scarsdale, New York.
Experts say it's good to look at this first, to see a company's current performance without depreciation and amortization, which can be affected by a lot of assumptions on the life of the assets they are using that can stretched over years, such as a 30-year depreciation of a piece of equipment, Wilson says.
"Looking at EBITDA normalizes things by taking the interest out and looking at how they are using the capital they have, regardless of whether it is borrowed or invested capital," Wilson says.
Scrutinize the depreciation. Every business is different and some depreciation is legitimate, Gerber says, such as a hotel that depreciates its rooms since they need to be replaced. But some companies are using it as a tax write off, such as a cable company that depreciates the cable it purchased 25 years ago even though it hasn't really lost its value, he says.
Review a company's taxes to see if they received a tax benefit that they are not going to receive in the future.
Look at the balance sheet, which describes where a company holds its assets, including cash, the types of liabilities such as loans and its equity. "Are they collecting their money or is their accounts receivable growing," Wilson says. "Are they paying all of their bills or is their accounts payable getting big?"
Read the footnotes. "You've got to read the part no one wants to read," Wilson says. "Reading the footnotes about how they are doing their accounting can be extensive and exhausting, but it's important."
Look at the proxy statement. This document is included in the annual report and discloses executive compensation, including golden parachute information, employee stock options and other shareholder proposals as well as biographies about the leadership team and other important information.
Review how much restricted stock is included in executive compensation. A poorly performing executive who is given significant compensation despite having an underperforming company is a red flag, Gerber says.
"You really need to look at what CEOs are getting paid and how much risk the executive is to the company doing well," says Gerber, who cites Twitter's (TWTR) high stock-based compensation for its executives as a percentage of revenue that has hurt its shareholders. "I want to make sure management is aligned with me."
When in doubt, listen to earning calls. Most websites have these calls archived. Listen to several earnings calls to learn the cadence of the executive team, suggests Patrick O'Hare, chief market analyst for Briefing.com, a Chicago-based research firm.
During each conference call, there's a point where financial analysts will ask questions of C-suite executives. As the CEOs and CFOs defend the company's performance and the perspective they are seeing, financial analysts may challenge what they are hearing to best determine the company's growth, outlook and stock valuation. Pay attention to the tone and verbal banter, O'Hare says. "You can hear the level of confidence or lack thereof provided by the executive."
By Dawn Reiss