While many of us may find earnings reports daunting, taking charge of your investments is the first step towards building a strong, self-sustaining portfolio.
Granted, not all of us are trained in accounting or finance, but you do not need to be an expert in either in order to understand the basics of an earnings report.
What it does take, however, is time and commitment on your part to understand what happened and to dig deeper if need be.
Today, I will be presenting a simple guide on the key aspects to watch out for when reviewing earnings reports.
Remember that for most companies in Singapore, there is a requirement to report earnings on a quarterly basis. That would mean that an investor will get a report card on how his investments are doing once every three months.
An earnings report will have three main types of financial statements:
- Profit and Loss Statement (also called the “Income Statement or P&L”)
- Balance Sheet (also sometimes known as the “Statement of Financial Position” or BS)
- Cash Flow Statement (CFS).
In simple terms, the P&L tells you how much a company has earned or lost, the BS informs us on the level of assets and liabilities a firm has, and the CFS shows us the inflow and outflow of cash from the business.
Revenue and Profit Movements
One of the first aspects I look at is whether revenue and net profit in the P&L have risen, or fallen.
This is usually fairly clear as companies will summarise the variance (in %) in the two figures from the prior period.
A company that grows its revenue suggests that the business is expanding and garnering more customers, but revenue may sometimes fall due to seasonality, cyclicality or due to competition.
Meanwhile, profit levels will rise and fall depending on the level of expenses incurred within the business.
It is important to read through the management discussion and analysis (MD&A) section (usually section 8 in SGX earnings announcements) and the press release (if any) to understand the underlying reasons for a revenue or profit change.
If revenue rose, was it due to better pricing, more volume or a combination of both? If sales fell, what were the reasons provided by management and are these reasonable when the investor considers the industry and business environment?
The same goes for profit levels – there are many reasons why profit will fluctuate, so investors should study the reasons carefully.
It’s always useful for an investor to browse through what management has to say. They can then compare successive quarterly reports to assess if there is a trend of revenue or profit movement that should either be lauded or ring alarm bells.
There may also be a one-off, exceptional gain or loss that may distort the financials during a financial period. The objective here is for the investor to put on his thinking cap in order to discern why the business has performed the way it has.
The next key aspect to look at is margins, an integral aspect of analysis for any business.
For me, margins measure a company’s efficiency in converting its revenues into profit. There are three key margins that investors need to track on an ongoing basis: the gross margin, operating margin, and net margin.
Gross margins represent the gross profit as a percentage of revenue which is an indication of pricing power for a company. In my view, the higher the gross margin, the more pricing power a company has.
Meanwhile, operating margins measure the level of expenses and how efficient the company is in generating profits with a certain cost base.
Net margins are similar to operating margins, but there is an added element of finance costs (i.e. expenses related to borrowings and loans) and also share of profits from joint ventures and associates.
Margin improvement is always a good sign, but investors need to understand the underlying reasons for the improvement and whether these are sustainable or just one-off.
When margins decline, the same question of “why” should also be asked to management. If the MD&A does not adequately explain margin movements, investors can consider taking this up to the Investor Relations department or ask questions during the Annual General Meeting.
Get Smart: Take time to read and understand
It’s important for investors to study these key income statement characteristics in order to discern how their investments are performing.
By reading a bit more deeply into the above aspects, investors can quickly gain a basic understanding of whether a company is doing well, or not.
I will talk about BS and CFS aspects that investors should watch out for in a future article, as well as elaborate more on the temperament needed for reviewing earnings reports.
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Disclaimer: Royston Yang does not own any of the companies mentioned.