Income Statement Analysis -Part II

First Three Lines of the Income Statement Investing Putting It Together Thus Far:
We’ve actually covered a lot of ground. Here’s an example to help reiterate and / or clarify everything we’ve discussed.

If the owner of an ice cream parlor purchased 10 cups of vanilla ice cream for P2 per cup, and sold each of those cups to her customers for P5, the first three lines on her income statement would look something like this:

Total Revenue P50(The total revenue is the amount of money rung up at the cash register. The owner sold 10 cups of vanilla ice cream to her customers for P5 per cup. 10 cups x P5 a cup = P50.)
Cost of Revenue P20(The cost of goods sold was 10 cups x P2 per cup = P20)
Gross Profit P30(The total revenue subtracted by the cost to earn that revenue is P30. Before taxes, and other expenses, this is the ice cream parlor’s gross profit.)
Gross Margin: .6 (or 60%)

Operating Expense on the Income Statement

Operating Expense

The next section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business. Operating expense consists of salaries paid to employees, research and development costs, and other misc. charges that must be subtracted from the company’s income. As an investor / owner, you want to work with managements that strive to keep operating expense as low as possible while not damaging the underlying business.
Selling General and Administrative Expenses (SGA)SGA expenses consist of the combined payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees), and advertising expenses a company incurs. High SGA expenses can be a serious problem for almost any business. A good management will often attempt to keep SGA expenses limited to a certain percentage of revenue. This can be accomplished through cost-cutting initiatives and employee lay-offs.

There have been several cases in the past where bloated selling, general and administrative expenses have literally cost shareholders billions in profit.

Non-Recurring and Extraordinary Items or EventsIn the unpredictable world of business, events will arise that are not expected and most likely not occur again. These one-time events are separated on the income statement and classified as either non-recurring or extraordinary. This allows investors to more accurately predict future earnings. If, for instance, you were considering purchasing a gas station, you would base your valuation on the earning power of the business, ignoring one-time costs such as replacing the station’s windows after a thunderstorm. Likewise, if the owner of the station had sold a vintage Coke machine for P17,000 the year before, you would not include it in your valuation because you had no reason to expect that profit would be realized again in the future.

What is the difference between non-recurring and extraordinary events? A nonrecurring charge is a one-time charge that the company doesn’t expect to encounter again. An extraordinary item is an event that materially* affected a company’s finance and needs to be thoroughly explained in the annual report or SEC filings. Extraordinary events can include costs associated with a merger, or the expense of implementing a new production system.
Non-recurring items are recorded under operating expenses.

*The term material is not specific. It generally refers to anything that affects a company in a meaningful and significant way. Some investors try to put a number on the figure, saying an event is material if it causes a change of 5% or more in the company’s finances.
Depreciation and AmortizationThere are two different kinds of "depreciation" an investor must grapple with when analyzing financial statements, accumulated depreciation and depreciation expense. They are entirely different things, and are often confused with one another. In order to understand them, we must discuss them individually.

Depreciation Expense

"Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. [emphasis added] Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred."

An Example of Depreciation Expense

To help you understand the concept, let’s look at an example of depreciation expense:
Sherry’s Cotton Candy Co., earns P10,000 profit a year. In the middle of 2002, the business purchases a P7,500 cotton candy machine that is expected to last for five years. If an investor examined the financial statements, they might be discouraged to see that the business only made P2,500 at the end of 2002 [P10k profit - P7.5k expense for purchasing the new machinery]. The investor would wonder why the profits had fallen so much during the year.
Thankfully, Sherry’s accountants come to her rescue and tell her that the P7,500 must be allocated over the entire period it is going to benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five [P7,500 / 5 years = P1,500 per year]. Instead of realizing a one-time expense, the company can subtract P1,500 each year for the next five years, reporting earnings of P8,500. This allows investors to get a more accurate picture of how the company’s earning power. The practice of spreading-out the cost of the asset over its useful life is "depreciation expense".

This presents an interesting dilemma; although the company reported earnings of P8500 in the first year, it was still forced to write a P7,500 check [effectively leaving it with P2500 in the bank at the end of the year [P10,000 profit - P7,500 cost of machine = P2,500 left over]. This means that the cash flow of the company is actually different from what it is reporting in earnings. The cash-flow is very important to investors because they need to be ensured that the company can pay its bills on time. The first year, Sherry’s would report earnings of P8,500, but only have P2,500 in the bank. Each subsequent year, it would still report earnings of P8,500, but have P10,000 in the bank since, in reality, the business paid for the machinery up-front in a lump-sum. Hence, if an investor knew that Sherry had a P3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of P8,500. In reality, the business would be P500 short.*
This is where the third major financial report, the cash flow statement, comes into an investor's analysis. The cash flow statement is like a company’s checking account. It shows how much cash was spent, at what time, and where. That way, an investor could look at the income statement of Sherry’s Cotton Candy Co. and see a profit of P8,500 each year, then turn around and look at the cash flow statement and see that the company really spent P7,500 on a machine this year, leaving it only P2,500 in the bank.

Accounting for Depreciation Expense in Your Income Statement Analysis

Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company’s profits because it requires no immediate cash outlay. In other words, Sherry wasn’t really paying P1,500 a year, so the company should have added those back in to the P8,500 in reported earnings and valued the company based on a P10,000 profit, not the P8,500 figure. This is incorrect. Depreciation is a very real expense. Depreciation attempts to match up profit with the expense it took to generate that profit. This provides the most accurate picture of a company’s earning power. An investor who ignores the economic reality of depreciation expense will be apt to overvalue a business and find his or her returns lacking.
*Depreciation expenses are deductible; Sherry’s would only pay taxes on P8,500 each year, spreading out her tax burden to the future. Some investors assume incorrectly that the business would pay taxes on P2,500 the first year and the full P10,000 each year after.