Unfortunately, 10-Qs, the quarterly earnings reports companies must file with the SEC, and 10-Ks, the annual version of the 10-Q, can make for tough reading. The SEC has requirements outlining what needs to be included in these filings to ensure that they are complete, but each report is written by the company in its own format and in such a way as to prevent legal problems. So you need to pick through the earnings report to really get at the meat.

Revenues, or sales, are one of the most important components of an earnings report. One-time gains should be excluded from revenues for the purpose of evaluating the long-term outlook, since one-time transactions do not necessarily reflect future transactions and are not part of the company's underlying business model.

Revenues and earnings should be moving in the same direction. Lower revenues and higher earnings means a slimmer profit margin, which may be unsustainable. Higher revenues and lower earnings means that income is being eroded by operating costs.

Where the money's going

The gap between revenues and earnings is created by expenses. Operating expenses, or overhead, are the costs of doing business, such as paying employees, leasing office space and marketing products. As with one-time gains, one-time losses should be excluded when looking at a company's long-term prospects.

If expenses grow faster than revenues, earnings will shrink. For a company that's growing rapidly, redirecting money to stimulate growth may make sense, but profits from the growth should be reflected in future earnings as revenues and expenses stabilize.

Items to watch for

Cash flow, a measure of how much money is flowing into the company minus how much is being paid out, should grow with earnings. Since cash flow looks at income without regard to fixed expenses, items such as taxes, interest and non-cash charges won't mask a company's ability to generate income from its core business. Information about cash flow can generally be found along with the discussion about liquidity.

Make sure the company isn't issuing unusually high levels of credit. Check accounts receivable to see how much the company is owed by customers who have purchased goods or services on credit. This gets tallied as a current asset even though the company has not yet received payment.

Look for consistency in inventory levels. Sudden jumps could signal overzealous production or shrinking demand in the marketplace. This is especially worrisome in the high-tech sector, where technological advances can quickly turn today's leading-edge product into tomorrow's obsolete clunker. To reduce stockpiles, management may have to offer steep discounts, which will cut into future earnings.

Watch for changes in research and development. If R&D expenditures fall, the company may become less able to keep up with competition. Increases in R&D expenditures should be accompanied by new and improved products. Otherwise, the company may not be spending wisely.

In addition to all the numbers, earnings reports contain a discussion of the company's financial outlook. Read the "Management's Discussion and Analysis" to put the numbers in context with the company's goals and strategies. This section should offer explanations for any figures that seem out of line. The financial outlook may also contain management's take on competition and industry trends that can affect business.