How to Understand an Earnings Report in an Hour

ORIGINAL POST DESCRIPTION: Learn how to decipher the financials in quarterly and annual reports. This is especially important if you work in the corporate world and you’re NOT an accountant.  In no small way, your career progression depends on whether you understand the financial health of your company.  So… using plain English… this walk gets into the details of income statements, cash flows, and the balance sheet.  It slowly (and hopefully clearly) goes line by line through a sample annual report (10-K) from a bank.

Even though I throw the numbers up on the screen, the best way to experience this walk is to look at page 73 of the annual report that I’m covering while you listen to the walk.  If nothing else, you’ll avoid motion sickness.  

The link to the annual report: https://ir.firstrepublic.com/static-files/89a1df66-7e28-4491-86aa-a331900db222

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If you don't understand the financials of the companies that you want to invest in– or have already invested in– you’re low-key jeopardizing your nest egg.  

But that’s not why I’m doing this walk.  Remember– every walk to date has been about how you– engineers mostly and some Ops partners– pick up both breadth and depth in the businesses that you support.  Why? Because you need business depth to be better business contributors.  Because advancing your career doesn’t just require you to be a great coder or some single-function operations expert.  The path to landing in the C-suite of any company– as the CIO or CTO or Head of Ops– can only happen if you have both breadth and depth in that business. 

That’s not true. You can land a C-level gig but you won’t keep it long. 

So… what does that have to do with understanding the financials of your company?  Being able to decipher your company’s balance sheet accurately is so foundational– so intimately tied to your credibility as a leader– that without that skill, I can confidently say that you'll necessarily be limited in your career.  Boxed forever into being a waiter, not a chef.

Ok.  Enough preaching.  Let’s get started.

A balance sheet is like going to your doctor.  Her job is to tell you how you’re doing since your last checkup.  If you’ve been eating healthier and exercising, she’ll tell you if it’s paying off.  If you’ve been sneaking chips and Pepsi, she’ll remind you not to.  It’s how you gauge results– see whether you need to diet or gain weight.  It’s not the only way to figure out where to focus your next set of actions… but if it’s missing from the list of your inputs, you’re operating at a disadvantage.

Some basics.  There are 3 sections to most financial statements… even though they’re consolidated in the one that we’re going to talk through… and those 3 common sections– each one is tied to the others. 

First, an income statement.  Also called a P&L… which stands for Profit and Loss (P- Ampersand-L… it sounds like you’re saying P–the letter N–L but if people would just pronounce the d in and… it would sound like P and L…. But everyone just says P&L). Anyway– the income statement– the P&L– shows the company's revenues and expenses during a particular time period. It shows how the revenues– all the money coming into your business– minus the expenses– all the stuff the company pays for– are magically transformed into the net income or net profit of your company. 

Why do they call it “net” anything?  It’s because businesses are like giant fishing vessels that pull in profits with giant nets.  No.  The word net is an accounting term.  Basically means you’re adding or subtracting numbers.  

Profit is non-specialist language.  Net profit… net anything– is specialist language… adopted from accounting.

So an example– and there’ll be a ton of them on this walk that uses the prefix net– the PNL starts with a number– sales– and after you subtract all expenses– see a subtraction– it leaves you with net profit. 

That was the income statement– the first of the three financial statements we’re going to cover.  The second is cash flow.  It starts where the income statement left off– with profit and it tracks how much cash is generated and used… ending with how much cash is on hand.

The third statement is the balance sheet… which starts with how much cash is on hand– see how it flows 1, 2, 3?  The balance sheet starts with cash-on-hand and subtracts liabilities from assets– and ends with shareholders’ equity. 

Beginning, middle, and end.  Income– some basic math– cash flow– some basic math– balance sheet.  Done. 

If only it were that easy.  Let’s get into the details.

Let's now go through an example.  We’re going to use the 10-K filing of an actual bank.  The 10-K is the form and format that companies use to publish their annual reports– at least those required by the U.S. Securities and Exchange Commission (the SEC).  A 10-K should in theory give us a comprehensive summary of the company's financial performance.

The example I’m going to use on this walk is the last 10K– the last annual report– that was published by First Republic Bank– their 2022 annual report.  If the name of that bank sounds familiar, it’s because they just went belly up– May 1st, last week.  They collapsed.  The Fed stepped in and sold them to JP Morgan.

I’m using them as my example because in theory– investors use a company's earnings reports to assess its financial position– to figure out if they should invest in the company or not.  And as you learn about how to read thru and understand earnings reports in general, it’s worth… reflecting… on whether the 10-K actually helps investors understand risks.  

I have my opinions.  You should form yours.

A quick disclaimer: I have never owned shares in First Republic but I did work for JP Morgan– an amazing company– where you will always be the dumbest person in the room.  At least I was.

I’ll also include a link in the description below to First Republic’s 10K… of which I have 1 glorious page in my hand… for reference.  And even though I’m going to provide the link to it, you can find it the way I found it: by googling [company name] 10-dash-K.  

In First Republic’s case, it was a 207 page document… with another 99 pages of exhibits… bringing it to a robust 306 pages.  I mention this because it’s an intimidating size.  It’s kinda meant to be.  Like when NY cops say “move on… nothin’ to see here.”  

Did I bring 306 pages with me on this walk?  No.  I brought one.  With two handwritten quotes on the back.  So don’t be intimidated.

The first 37 pages of this particular 10-K are a description of what First Republic– as a generic, run-of-the-mill bank does – Banking 101.”  If you’re not familiar with banking– read it.  But know that regardless of the company or the industry, it’ll be lightly sprinkled with marketing bs.  First Republic’s for instance starts its section on Business Strategy with [READ] “Our core business principles and service-based culture have successfully guided our efforts over the past 37 years.”  And what do we know about past performance?

Pages 38 to 68– the next 30 pages– is a section called Risk Factors… which holy-moly, that should be interesting, right… for a bank that went under… but that’s where they explain in the most generic possible way things like credit risk, market risk, default risk… which reads like a cut-and-paste job from Investopedia to be honest.  They go into some detail but it’s mostly a head fake– false detail like… when talking about credit risk, they write  “California has had and will continue to have major earthquakes in many areas.”  Yeah.  That’s what investors need to fear: Acts of god.

So… nothing useful until page 73– this one— their income statement.

Let’s go through it.  And I’ll put it up here when I get home.  First, a quick, high-level- read of the page– the kind of thing you’d want to do when the report was just released… within minutes of it being posted.

You skip all the banking 101 crap and jump to the income statement, the earnings statement.  A lot of people call that the P&L, which we talked about– short for profit and loss.

At the top, right above all the numbers, it says “for the year ended December 31st, for 2020, 2021 and 2022.  So you're seeing 3 years worth of results– that’s standard.  And the fiscal year-end for First Republic happens to be the same as a calendar year-end. A lot of companies do it that way.

There are certainly companies that have a non-end-of-calendar-year, end-of-fiscal-year… and that’s usually determined by how busy they are around Christmas time. If you’re a Walmart or a chain-retailer, you’ll want to pick a different time of year to do the hard work of closing out your accounting books.  Plus it’s a show.  You get in front of your investors and do a little dance. You certainly don’t want to do it on Black Friday… because it would distract you and your investors from all the good fights.

Now, back to the P&L on page 73 here.  What are you looking for?  Think:  sales minus costs equals profit.  On this page,  the very top line is interest income…. Which (along with line 6 – non-interest income) is a bank’s equivalent to total revenue– all the money coming in during this period– which to other non-banking companies could be thought of as sales.  All money inbound.

So that top line… is the literal top line that CEOs and CFOs talk about on earnings calls.  Top-line growth… refers to that actual top line…  And if that blows your mind, wait until we get to the bottom line.

Top line growth for this bank is how much that literal top line grew from 2020 to 2021 to 2022… from $3.853B to $4.385B to $5.722B.  That’s a 14% increase from 2020 to 2021 and a 30% increase from 2021 to 2022.  The numbers 14% and 30% aren’t on the income statement so you’ll need a calculator… but you get the point.  That’s really impressive top-line growth.  I should totally invest in this bank… said a lot of angry people six months later.

Next line down… repeat the mantra… sales *minus costs* equals profit.   So the next line down is a cost…. In this case interest expense. That’s… any Checking accounts that *they* pay interest on, any money market savings accounts (again that *they* pay *their* customers), any CDs they've issued... That's about half of their interest expenses.  The other half is anything they're paying on… money they've borrowed: federal funds, FHLB advances (which are a funding source for a variety of mortgage products), senior notes, subordinated notes... which we talked about on the private equity walk.

So that second line across-- the $888M, $271M, $591M... those are some of their expenses (at least tied to their interest income).  How do I know that from just looking that the words "interest expense"?  I don't.  It's not on page 72.  It's a little chart that looks very similar to this on page 83.  You can do what I did if you have the earnings report document open in front of you and you're like "What the hell is "interest income"?  or "Provision for credit losses"? Do a search on it in the same doc and there'll be an explanation later in the same doc.  

Ok... see that line that separates line-two (interest expense) from line-three (Net interest income)?  The line under 888... 271... 591.  That's basic arithmetic for "I'm about to subtract.  So... 5722-888 is 4834.  The NET interest income... because what does net mean? We did some subtraction.

Just like one line down... 4834 minus 107 is... 4727.  In that case, they're subtracting what they call "provision for credit losses" from Net Interest Income... What are the "provisions for credit losses?"  Control-F on your keyboard... search for the details in the same doc... and you'll get-- that it's a way of estimating potential losses tied to credit risk.  This particular document makes that particular search result hard to understand by using an acronym ACL.. that they define in a glossary of three-letter acronyms.  ACL stands for Allowances for Credit Losses.  If you still don't understand it, google it until you do.  ACL is an estimate of the debt that a company is UN-likely to recover.  It's the lending equivalent of the sweatshirt your friend in high school borrowed.  You're never seeing it again.  ACL -- Allowances for Credit Losses.

In plain English, the line called provisions for credit losses is saying... hey, there's been a change in economic conditions-- in the macroeconomic outlook, and given historical loss rates... well... you know that sweatshirt we lent out...  Sorry. Not sorry.

It's not that simple... because they'll use finance jargon in the rest of the doc-- fancy words like "capital calls" which basically means that someone they borrowed money from is sick of their shit... and wants it back... now!

So look at that fourth line:  $107M in 22, 59 in 21, 157 in 2020... that's a lot of sweatshirts First Republic had to write off.  

Alright... 

working our way down... 

You subtract the provisions for credit losses (expensive sweatshirts) from Net interest income and voila: Line 5: Net interest income after provision for credit losses.  It's almost like they know we're stupid.

The next line down is the second way they make money… remember line 1–interest income— well that and this line line 6- together is all inbiund money.  Interest income and non-interest income.  

This line though is the line that made them an attractive fire-sale option to JP Morgan.  Their noninterest income are things like their investment management fees, their brokerage and investment fees… because in addition to the boring checking/savings accounts they offer…. First Republics also does wealth management (and it grew by 45% in 2022).   So if you’re JP or Goldman… and you can buy high-net-worth wealth management clients at firesale prices… why the hell wouldn’t you… they’re the most lucrative client segment in the next 20 years.  Anyway… that line… line 6 also includes insurance fees, Trust fees, Foreign exchange fee income, Deposit fees, Loan fees.  How do I know all this?  Control F…. search in that doc.

And you can’t have income– line 6– without its related expenses– line 7:  non-interest expense.  This one’s easy. It’s employee salaries, employee benefits, the company’s tech footprint, their real estate occupancy, advertising and marketing, etc..etc…

Not every earnings report you’ll read will call it non-interest expense… because not every company is… like a bank… making most of its money from interest income.  But this walk is less about how banks do it or how First Republic used to do it…. This walk is about how YOU learn to fish… how you can control-F your way to understanding any earnings report.

And that– seemingly– gets us to line 8… the bottom line number… literally… and that’s net income: $1.665B in 22, $1.478B in 21 and $1.064B in 20.  Net income… by the way.. is also called profit or a company's bottom line.

Before we move on though… get your calculator out.  Because if you add all the income numbers for each column or year and subtract all the expenses… it doesn’t add up to the net income numbers on page 72.

You’re off by $476M in ‘22, $350M in ‘21 and $270M in ‘20.   And that’s because they titled that page “Selected Financial Data”... not “All Financial Data.”  Those missing sums are what First Republic paid in taxes.  

I’m actually not sure why they wouldn’t list taxes on that page right before the net income line.  Maybe it’s an accounting practice.  I don’t know.  I have two guesses:  1) they don’t expect anyone to tabulate the numbers in their head when looking at a page filled with numbers.  Cuz that would be too Rain Man.  Or 2) they’re ashamed to admit to potential investors how much they pay in taxes.  I honestly don’t know.  I just know that it’s torture for people who can do math quickly in their heads.

It’s like playing every note but the last one on a familiar tune.  Dun duna dun dun… dun…. (missing).

It’s torture.

Anywho… as you look at your next earnings report… as you zero in on that bottom line net income– whether you’re an investor or an employee– you’ll want that number to be higher.  Always.  Because… nom nom nom nom nom.  More equals better.  And as obvious as it sounds, it’s worth calling out that there are really two levers you can pull to increase that number:  1) increase the company's total revenue (the money that’s coming in), and/or 2) decrease the company's costs (the money that’s going out). There it is… in 1 sentence…you just became a CEO.  Like in the Shawshank Redemption: Get busy selling or get busy cutting.

Ok… 

So how do you do this all quickly?  Everyone has their method.  Mine: Zero in on the company's total revenue.  See if it’s growing year over year… preferably compare that in your head to comparable numbers that you’d memorized beforehand… specifically the numbers of that company’s competitors.  If you’re thinking about investing in MySpace in 2008– before you even read their 10-K–  before you find out that they grew total revenue by 80% year over year… well, you should have memorized the appropriate context numbers… of their competitor… Facebook… which grew by 500%... or you do that with numbers from outside that industry and compare MySpace and Facebook to– what the hell would compare in 2008 to Facebook’s sales… cocaine sales by the Mediyeen cartel…  a million percent.

My point is that you don’t start cold with your company’s earnings report.  You don’t just come to that read with the analyst-community’s whisper numbers in your hand.  You always need business context… a competitive context.

So… 1) you zeroed in on total revenue and it’s growth year over year….  Next, take a gander at how much net income grew in the last year. And you can see between this year and the year before– so in our case between ‘21 and 22… First Republic grew its net income… between 12 and 13%.  It’s not on the sheet so you’re using a calculator or that walnut between your ears to do the math.

Compare that to your competitor numbers.

Next, 3) look at the company's net profit margin. That’s net income as a percent of total revenue.  In First Republic’s case, they use what they call “Net Interest Margin”... look for it up here… it’s shrinking from 2020 to 2021 to 2022… 2.72% in 20, 2.67% in 21, and 2.65% in 22.  Why?  Because interest rates are going up →  They’re paying more to their customers… to their lenders…. so their margins are shrinking.

That might or might not be bad… when you compare it to your memorized business context numbers.  They probably won’t look bad when compared to other banks… because all banks are experiencing similar macroeconomic headwinds…. But it’ll probably look bad if you’re comparing to non-banks… or industries that aren’t as critically impacted by interest rate hikes… for instance… the Mediyeen cartel…. Are they even still around?

The point?  Compare all the numbers you now know how to find in your earnings report to other companies in your industry (and more broadly) to see if your company is a better investment than theirs.

If you grew up in american kid and you loved baseball cards… this is trading cards for businesses. 

And that was  a quick 3-step way to pick the right cards… to evaluate an earnings report and dazzle your friends at work.

How do you do more detailed analysis?

Start comparing each of those sets of numbers to each other.  

So let’s say that your revenue numbers look healthy… year over year… you’ll want to compare them to how much your expenses increased… year over year.   Because that gives you a sense of how scaleable those businesses are.  If every sale– every increase in income comes with a comparable increase in expenses, well… you don’t have as scaleable a business as a company where you can make more money without spending as much.

What else? If you look at the bottom line or net income… year over year…  and you see that it’s not just increasing but increasing at an increasing rate… yay… healthy growth.  

If you care about details, ratios are your friend.  In fact, the middle chunk of page 72 here… is a list of “Selected Ratios…” which I’ll put up here when I get home.

Basic EPS… earnings per share.  I can’t believe I didn’t cover this already.  You calculate EPS by taking a company's net income… subtracting it from dividends that they’ve paid out and dividing that amount by the average number of outstanding common shares.

EPS is a ratio.  Find where it says Net Income for 2022… $1.665B… subtract from that… the $158M they paid out as dividends…  you get $1.507B… and you divide that by the number of shares that First Republic has… 181M (which is not on this page but findable in the doc…. And BAM: you get 8.32… EPS earnings per share. 1507 divided by 181.

Given that all 10-Ks love the EPS ratio, as an investor you can use it as a cross-industry measure of company performance… without knowing or caring if that company is in banking or they make cookies or video games.

Given that EPS drives stock prices, how do you increase it? Two simple levers.  And I’m just talking math here… not operational methodology…. You either increase net income or you can decrease the number of shares.  That is why it’s commonplace for CEOs to buy back shares of their stock… They retire those shares they’ve bought back and BAM: EPS improves.  

Ok… what’s a diluted EPS?  It’s EPS with a lot of ice.  No.  It’s the same calc but instead of dividing by 181– the number of outstanding shares– you divide by that plus… outstanding RSUs… restricted stock units (RSUs)… shares you’ve already promised to your workers.  It’s the dilutive effect– in this case– of the company having 2M RSUs outstanding… a detail from another page…  So the denominator isn’t 181M, it’s 183M…  1507/183 gets 8.25… that’s rounded up.

I’m not going to walk through every ratio up here but you get the idea.  And if you’re super interested, each ration has an Investopedia description in somewhat plain English. This whole section– Selected Ratios– is the company trying to be helpful to you by doing the math for common ratios. They’re useful if whoever you’re comparing them to also uses the same ratios.  Not always true… but it is what it is.

Once you begin to understand your company’s earnings, you’ll start to pick up patterns that make sense to you… and what you care about.  You might latch on to how your bottom line number (your net income line) is growing faster than total revenue or the top line.  And you’ll figure out that that’s great for a mature company– you want to see that in dinosaurs.

With startups, you’ll see a different pattern because, at their stage, sales are more important than bottom-line profit… the reason being that you're trying to build a customer base, to get a foothold in the market. 

Would it be great if you saw profits growing faster than sales?  Hell yeah.  Scalable business.  Or a great management team focused on keeping costs down… increasing economies of scale…  because a focus on efficiencies always increases profits.  Almost always.

What didn’t we talk about… that’s important?  Operating expenses!  What First Republic called Non-interest expenses.  Other companies call that “fixed costs” because they're not directly tied to what you’re selling.  Think… real estate costs, marketing, research and development, administrative costs… like that expensive CEO.  It’s all overhead.  And it all gets a lot of focus when a company wants to create efficiencies… well, except for the expensive CEO… Their paycheck is safe.

We also didn’t talk about depreciation and amortization. These are non-cash expenses.. which track stuff that’s wearing out over time.  Plant equipment depreciates.  Software that you’ve written depreciates.  Its value decreases over time.  It's an operating expense.  

When you subtract out operating expenses, you get something called operating income… which some CEOs call this EBIT (pronounced e-bit)... it’s an acronym– stands for Earnings Before Interest and Tax.  

And if that acronym wasn’t long enough… there’s EBITDA. Earnings Before Interest, Taxes, Depreciation, and Amortization. 

Potato, pohtahto.

Warren Buffett and Charlie Munger call EBITDA utter nonsense.  They urge investors to ignore it.  Because EBITDA is– they claim– used to deceive investors and discount the importance of depreciation.  And… they’re both smarter than me so… they’re on to something.  Google it as you learn how to navigate your earnings reports.

Normally I’d end the walk there… but… there’s a reason I picked First Republic.  I could just as easily have picked Silicon Valley Bank or any bank that’s gone under– Lehman Brothers where I worked… before I didn’t work there!  

The problem that the business community needs to solve is that 10-Ks all read like everything’s great.  They’re mostly sales jobs.  They lack the metrics that signal real smoke.  Or if the signals are there, they’re intentionally hidden in 207 pages… or in the other 99 pages of exhibits.

Those signals might not be in the 10-K, but they are there.  How else would the Federal Reserve know when to step in?  They’re not following Twitter.  They’re not waiting for a run on the bank.  

They’re looking at capital calls… and trends in overnight borrowing…. Metrics that don’t land in 10-Ks… leaving investors unprotected.

As I said– 10 feet back– that’s a problem that the business community needs to solve.  Because if it can’t… as much as we all hate the burden of regulations… they’re there to protect investors.  You and me.

Ok… I hope you got something out of this.  I’ll see you at the next earnings call.