The Magic Numbers: What Matters in This Season's Earnings Reports - TheStreet

There are some documents that you can afford to skim over --

Publisher's Clearinghouse

sweepstakes, Checkers board game directions.

And there are some -- earnings statements from the companies whose stocks you own -- you can't.

Third-quarter earnings reporting season is nearly upon us, meaning that in the coming weeks thousands of companies will post their results. The preannouncement season -- when companies give Wall Street a heads up that results won't meet expectations -- is winding down, with

Xerox

(XRX) - Get Report

,

Apple

(AAPL) - Get Report

and

Eastman Kodak

(EK)

among the casualties. There shouldn't be many more warnings, so investors can turn their attention to the actual results.

But that doesn't mean that more warning signs might be lurking behind a seemingly positive report that includes bottom-line results -- net income -- in line with expectations. While most earnings reports may seem like an unnecessary jumble of numbers and convoluted business parlance, the story of a company's financial performance and fiscal health can often be gleaned from the small print. Investors need to know not only the basics of earnings reports but also how to dig deeper for harbingers of performance.

The standard report includes three essential elements: an income statement, a balance sheet and a statement of cash flow. The income statement covers a summary of a company's sales revenue and expenses, the balance sheet discusses the company's assets and liabilities, and the statement of cash flow shows money received from profits and what the company did with its available cash.

Of greatest significance to investors -- meaning the stuff that makes it into the headlines in the business papers and

CNBC

-- is earnings, or net income, which represents a company's total revenue minus the cost of operations and expenses. Another key number is earnings per share, which is calculated by dividing earnings by a company's total shares outstanding. For a further understanding of what's going on behind the scenes, here's a list of bases to cover when assessing a company's health:

One-time Cash Infusions

They might bolster earnings, but one-off cash windfalls from lawsuits or pension plans can be deceptive, says Steven Kaye, a financial planner at the

American Economic Planning Group

in Watchung, N.J.

For example, the soaring stock market has meant that many companies have received a large return from their pension plans. The money is usually included as revenue, but has nothing to do with the company's business, Kaye says. "We've seen companies that make it look as if they have made $3 billion in profits, but in fact most of that came from an overfunded pension plan."

Sales Trends

For certain, growing sales means that the company is healthy, but it's also important to examine a company's sales trends, cautions Kaye. "Find out what percentage of sales are on credit, and if that number is trending up then the company might be forcing its product on its customers, making sales more suspect."

When examining sales investors should also compare the current figure with the one for the year before and also with numbers for a close competitor in the industry, says John A. Tracy, a CPA and professor emeritus of accounting at the

University of Colorado at Boulder

. "If

General Motors

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reports a downturn in sales and

Ford

(F) - Get Report

reports an upturn, what's going on?"

Also, make sure when you check the sales numbers. Look closely to see if a big percentage increase is the result of improved performance or a recent acquisition.

Inventory

Lean and mean are the watchwords for most companies when it comes to inventory. The number tells you how quickly the stuff a company makes is going out the door, so if a company's inventory is increasing compared with other companies in its industry, it could be a warning sign that they are losing market share, says Tracy. "If other companies are getting beaten up it's not so bad. But if this happening to your company alone it could mean its inventory is not getting sold an the company might have to drop prices."

Stock Options

The practice of awarding stock options has spread from dot-coms to other industries, and it has now become an important consideration when reading a company earnings report, Tracy says.

Stock options have an often undetected but very significant bearing on a company's profits, Tracy says. When extra stock is issued it dilutes the value of existing shares, he adds.

The Small Print

Companies reporting earnings shortfalls this quarter have blamed their expected poor performance on the weak euro, high oil prices and slowing demand for their products. But that may not be the whole story. Other company-specific reasons for bad news affecting a company aren't always so easy to identify, says Kaye. "I usually look at the footnotes first because they will point to any extraordinary events," he says.

Similarly, it pays to study a company's performance over time. Annual reports are usually subject to more stringent laws and so contain more valuable information for investors, says Philip Wolitzer, a CPA and professor of accounting at

Long Island University

in Brooklyn, N.Y. "Sometimes it's foolish to just look at quarters because companies can shift information between them, but it's harder to do that from year to year."

More Red Flags

Other areas to examine for potential warning signs include large expenses that affect the bottom line -- for example, the

Bridgestone/Firestone

tire recall. Product recalls or a major restructuring can be costly, says Kaye. Red flags are also found in the auditor's letter, compiled by an outside examiner for the company. "The language in these letters is usually benign, so if the auditor has something important to say about the company you'd better pay attention."

In fact, when it comes to language certain words can be excellent signals for potential problems, Kaye adds. Trigger words include "contingent liabilities" (this can indicate potential legal or environmental problems looming on the horizon); "planned acquisition" (this means the company might be about to spend a lot of money) and "restructuring," he says. "This usually means a change of divisions and accounting procedures, and if it needs to be restructured means that something is going wrong."