Understanding earnings

Decode the confusing terminology used to report company performance.

Adam Zoll 14 March, 2014 | 6:00PM

Question: When companies report their financial performance, I hear terms such as "earnings," "profits" and "revenue," but I don't understand the differences. Can you clarify what these and related terms mean?

Answer: Some investors may be left scratching their heads at the variety of financial terms mentioned in news reports and company documents. If you're one of the many who has trouble keeping them all straight, here's your guide to some of the most important metrics that publicly traded companies are required to report each quarter and at the end of their fiscal years. Terminology used here is consistent with that used on Morningstar.ca under the Financials tab of each stock report.

Revenue: Quite simply, this is the amount of money the company has brought in for goods and services provided over the given time period. Revenue growth, in particular, is a statistic to watch because it may indicate whether the company's business is growing or declining.

Gross profit: The amount of company revenues left over after subtracting the cost of producing the goods and/or services it has sold. These include costs such as raw materials, salaries of the workers who make the products or deliver the services, and other production-related expenses.

Operating income: The amount left over after subtracting the company's operating expenses from gross profit. Operating expenses include the cost of selling the company's goods and services, administrative costs, and other costs of running the business, including depreciation of assets.

Net income: The company's profit after all expenses are taken into account, including not only the cost of producing and selling the goods and running the business but also taxes, interest income and interest expenses. This is one of the most closely watched measures of a company's profitability and value to shareholders.

Earnings per share (EPS): The amount of the company's net income divided by the number of shares of common stock outstanding. It typically offers a good indication of the company's level of profitability. However, the number of shares outstanding may change over time due to company buybacks and splits, which can affect this number.

Diluted earnings per share: This is similar to the earnings-per-share calculation, but factors in the potential effects of any outstanding convertible shares (preferred shares or bonds that can be converted to common shares), stock options and warrants.

Cash flow from operations: The amount of cash brought in by the company's operations before any investment or financing. This differs from net income since it directly measures payments received by the company as opposed to factoring in depreciation, taxes and other accounting steps. Some people prefer this metric to net income as a measure of company profitability because it is less subject to company manipulation.

Free cash flow: Cash flow from operations minus capital spending, or expenses incurred to help grow the company. It represents the amount of excess cash flow that could be passed on to investors and is often taken as a sign that a company may be profitable beyond its need to invest in itself. However, free cash flow is a non-standardized accounting measure and can be calculated in various ways.

EBITDA (earnings before interest, taxes, depreciation and amortization): This may be used as an alternative to net income for companies with heavy depreciation charges. However, this metric is not subject to standardized accounting rules, meaning it complements but does not serve as a substitute for net income.

How these statistics are used
To illustrate the role each of these financial statistics plays in reporting a company's performance, let's use an imaginary example we'll call XYZ Enterprises. Last year the company brought in a total of $100 million, which was its revenue (all numbers are purely for illustrative purposes and not meant to reflect the real world, so please hold your fire, accounting pros). However, its goods and services cost $60 million to produce, leaving it with a gross profit of $40 million. Take away from that $40 million gross profit the $25 million it cost XYZ to sell its goods and services, staff its headquarters, and for other expenses related to running the business, and you get an operating income of $15 million. But after $5 million in taxes and interest payments are taken into account, you are left with $10 million, which represents the company's net income, or profit. The company has 20 million shares of common stock outstanding, making for earnings per share of 50 cents for the year. But if all its convertible shares, options and warrants were to be exercised, it would have a total of 22 million common shares outstanding, which makes its diluted earnings per share about 45 cents. The company's cash flow from operations is $12 million, but if you factor in capital spending designed to grow the business, it ends up with free cash flow of $10 million. Finally, if you were to look at its earnings prior to stripping out taxes paid, interest, depreciation and amortization, you'd end up with an EBITDA of $20 million.

Areas of focus
As stated above, earnings per share tends to be the key statistic for investors to pay attention to because it indicates the company's level of profitability and how that profitability corresponds to the number of shares of stock outstanding. Cash flow also tends to be closely watched as a way to gauge just how much money the company is bringing in without other accounting line items getting in the way.

In addition to the aforementioned terms, investors may need to know terms used for companies in specific industries. For example, same-store sales (sales from stores that have been open at least a year) tend to be a closely watched barometer of how a retailer is doing. As well, energy companies often report both upstream and downstream earnings to differentiate how their production (upstream) and delivery (downstream) operations are performing.

About Author

Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com