The Importance Of Earnings

By Joe Ponzio on July 16, 2007  |  7 comments

Earnings. The Golden Child of Wall Street. You can't talk about a "growing" company unless you qualify your rant with a discussion of earnings. In fact, earnings are the basis of nearly every one of Wall Street's tests to determine whether a company is healthy and whether or not it belongs in your portfolio.

F Wall Street...and their earnings.

What Are Earnings?

Go ahead—ask Google for a definition of "earnings". As you look through the definitions, you'll notice that earnings are, in the business world, the amount of profit a company generates after all costs, expenses, and taxes have been paid. Seems pretty straightforward, no? Or, is it?

Let's put this into Plain English:

Your Earnings

If you were a publicly traded company, your earnings would be the amount of after-tax income stated on your tax return. Think about that for a second. Now think about this: What does your tax return tell you about your financial health? What does it tell you about your credit card debt? Do you sweat about money some times, and then check last year's tax return to find comfort in the numbers?

If you are like most people, you likely file your taxes every year, check to see how much your return is (or how much you owe), and then shove that return into a file folder. Like most people, you probably understand that your tax return is a formality, and that you can only judge whether or not you are financially growing by looking at how much money you are saving each month, above and beyond the checks you have to write and the cash you have to spend. And if you don't have the cash to pay your bills, you know that you have to whip out the credit card...and take a leap backwards financially.

Where's that on the tax return?

But...Companies Are Different, Right?

Wrong. A company's earnings is that company's after-tax income as stated on its tax return. Earnings, for the most part, tell the IRS how much in taxes they should be expecting from the company.

You know what? Companies have to pay bills too. If the company isn't generating enough cash to pay those bills, it has to start racking up debt or selling more stock to get the cash it needs to pay bills. Sure, the company can sit on its bills for a few months—we shareholders would never know the difference. But in the end, its suppliers won't take "earnings" as a form of payment. If there isn't enough cash to clear the checks, our high-tax-paying business with stellar, increasing earnings will have to start finding other ways to keep the doors open.

Don't Earnings Turn Into Cash—or Vice Versa?

Not quite. Again, turn to your personal finances. The amount of money you spend on your credit card payments, car loan, or daily coffee doesn't show up anywhere on your tax return. You can blow cash on a lot of things and never see it in your "earnings".

On the other hand, you can have millions of dollars in earnings each year, and be living paycheck-to-paycheck. What good is a $200,000 a month paycheck if you're spending $220,000 to pay your bills?

Earnings Follow Cash

In business, earnings follow cash. To increase earnings, businesses must generate enough cash to put the people and systems in place to generate and handle increased sales, and hence increased earnings. On the other side of the spectrum, businesses that can't generate enough cash have to start raising money elsewhere—selling stock, borrowing money, or shedding assets—or else sales and earnings will fall.

Worldcom—Accounting Scandal and Bad Business

You need not look further than the Worldcom example, though you can pick your own analysis from the hundreds of companies that never stood a chance at growth. Sure, Worldcom was wrought with accounting frauds which ultimately helped lead to its legal problems.

What, you say, were those accounting frauds? Worldcom wasn't generating excess cash from its operations. Rather than admit that it was having problems and that its earnings would follow its free cash flow down the tubes, Worldcom and its accounting firm, Arthur Anderson, played Wall Street's favorite game—look at our earnings, not at our business.

What other companies ran into "earnings" problems and precipitous stock drops? Lucent. Enron. Perhaps you've heard of them? Take a look at the tricks their accountants pulled to fake the IRS and Wall Street into believing they were growing. Then, look at their businesses and their inabilities to generate excess cash, say, "Oh, wow! I could have seen it coming from a mile away," and stop playing Wall Street's accounting games.

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