Income Statement Analysis

Income Statement Analysis

Introduction

Purpose of the Income Statement

The primary purpose of the income statement is to report a company's earnings to investors over a specific period of time. Years ago, the income statement was referred to as the Profit and Loss (or P&L) statement, and has since evolved into the most well-known and widely used financial report. Many times, investors make decisions based entirely on the reported earnings from the income statement without consulting the balance sheet or cash flow statements (which, while a mistake, is a testament to how influential it is).

Using Income Statement Analysis to Calculate Expenses, Earnings, Financial Ratios and Profit Margins

To an enterprising investor, income statement analysis reveals much more than a company's earnings. It provides important insights into how effectively management is controlling expenses, the amount of interest income and expense, and the taxes paid. Investors can use income statement analysis to calculate financial ratios that will reveal the rate of return the business is earning on the shareholders' retained earnings and assets; they can also compare a company's profits to its competitors by examining various profit margins such as the gross profit margin, operating profit margin, and net profit margin.

Beginning our Analysis of the Income Statement

As we progress through this series of investing lessons, you must remember the basic truth that a business is only worth the profit that it will generate for its owners from now until doomsday, discounted back to the present, adjusted for inflation. The income statement is the "report card" of those earnings, which ultimately determine the price you should be willing to pay for a business.

Sit back in your chair, take out a copy of an annual report, flip to the consolidated income statement for the most recent year, and let’s begin working through it. In the end, I think you’ll be surprised by how much you’ve learned. As always, there will be quiz following the lesson; you should be able to pass without missing more than two questions.

Total Revenue or Total Sales Investing

Total Revenue or Total Sales. The first line on any income statement is an entry called total revenue or total sales. This figure is the amount of money a business brought in during the time period covered by the income statement. It has nothing to do with profit. If you owned a pizza parlor and sold 10 pizzas for P10 each, you would record P100 of revenue regardless of your profit or loss.The revenue figure is important because a business must bring in money to turn a profit. If a company has less revenue, all else being equal, it’s going to make less money. For startup companies and new ventures that have yet to turn a profit, revenue can sometimes serve as a gauge of potential profitability in the future.Many companies break revenue or sales up into categories to clarify how much was generated by each division. Clearly defined and separate revenues sources can make analyzing an income statement much easier. It allows more accurate predictions on future growth. Starbucks’ 2001 income statement is an excellent example:

Starbucks CoffeeConsolidated Statement of Earnings – ExcerptPage 29, 2001 Annual Report
In thousands except earnings per share


Fiscal year ended
Sep 30, 2001
Oct 1, 2000
Net Revenues


Retail
P2,229,594
P1,823,607
Specialty
419,386
354,007

Total net revenues
2,648,980
2,177,614

Starbucks’ sales come primarily from two sources: retail and specialty. In the annual report, management explains the difference between the two several pages before the income statement. "Retail" revenues refer to sales made at company-owned Starbucks stores across the world. Every time you walk in and order your favorite latte, you are adding P3-5 in revenue to the company’s books. "Specialty" operations, on the other hand, are money the company brings in by sales to "wholesale accounts and licensees, royalty and license fee income and sales through its direct-to-consumer business". In other words, the specialty division includes money the business receives from coffee sales made directly to customers through its website.

Cost of Goods Sold - COGS Investing

Cost of Revenue, Cost of Sales, Cost of Goods Sold (CGS) Cost of goods sold (CGS for short) is the expense a company incurred in order to manufacture, create, or sell a product. It includes the purchase price of the raw material as well as the expenses of turning it into a product. Cost of goods sold (CGS) is also known as cost of revenue or cost of sales.

Going back to our Pizza Parlor example, your cost of goods sold (CGS) include the amount of money you spent purchasing items such as flour and tomato sauce.

Gross Profit Investing

Gross ProfitThe gross profit is the total revenue subtracted by the cost of generating that revenue. It tells you how much money a business would have made if it didn’t pay any other expenses such as salary, income taxes, etc. Gross Profit should be broken out and clearly labeled on the income statement. Here’s the formula to calculate it yourself:

Total Revenue - Cost of Goods Sold (COGS) = Gross Profit

The gross profit figure is important because it is used to calculate something called gross margin, which we will discuss later.

Gross Profit Margin. Although we are only a few lines into the income statement, we can already calculate our first ratio. The gross profit margin is a measurement of a company’s manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue / sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient.

Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled [overhead refers to rent, utilities, etc.]

To calculate gross profit margin, use this formula:

Gross Profit----------(divided by)----------Total Revenue

For illustration purposes, let’s calculate the gross profit margin of Greenwich Golf Supply (a fictional company) using its income statement.
Greenwich Golf SupplyConsolidated Statement of Earnings – Excerpt
In thousands except earnings per share


Fiscal year ended
Sep 30, 2001
Oct 1, 2000
Total Revenue
P405,209
P315,000
Cost of Sales
P243,125
P189,000
Gross Profit
P162,084
P126,000

Assume the average golf supply company has a gross margin of 30%. We can take the numbers from Greenwich Golf Supply’s income statement and plug them into our formula:

P162,084 gross profit----------(divided by)----------P405,209 total revenue

The answer, .40 [or 40%], tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors.

The gross margin tends to remain stable over time. Significant fluctuations can be a potential sign of fraud or accounting irregularities. If you are analyzing the income statement of a business and gross margin has historically averaged around 3-4%, and suddenly it shoots upwards of 25%, you should be seriously concerned.