Income Statement Analysis
Income statement analysis is related with research of company's revenues and expenses and comparing the figures to its past and industry peers.
Income statement analysis is the first step of researching financial statement forms. The easiest way to find income statement of companies is to browse investor's corner of their websites, where you will most often find quarterly and yearly reports.
Professional investors do an income statement analysis immediately after the company publishes new quarterly report, because that is the moment when public is informed of the latest business results, how much did the company earn (revenues), how much did the company spent (costs) and how profitable were their activities (earnings) in the latest time period.
The very first thing an investor should check while reading income statement is weather the company is making money or not; if the company is spending more money than it brings in, you should be very careful before investing in such company's stocks. On the other side, if expenses of the company are well under control and they manage to generate much higher revenues, you should rank such company as the one with strong fundamentals and put it on the top of the list of stocks for potential investment.
Revenues
Revenues or sales are the first figure you should research when doing income statement analysis. You can find this figure on the top of the statement, most often as one single number, which can be broken down geographically or by business segment with bigger companies.
What you should research in depth is the dynamic of company's revenues over the years and within the year. it is a positive sign, if the company is increasing its revenues constantly and improving its profitability in this way. If there are only temporary increases of revenues because of some marketing activities, it is not as powerful as constant improvement. Stabile growth of revenues is what you are looking for.
Expenses
Every company involved in business has many kinds of expenses. The most common are expenses related to the cost of goods sold (COGS), other operational expenses and financial expenses.
Costs of Goods Sold
COGS is the expense directly related to producing (how much is the cost for the company to produce the good or service) or purchasing (how much is the cost for the company to purchase the good or service) the goods or services sold by the company.
Operational Expenses
Operational expenses includes all the other expenses related with the company's business, like marketing costs, salaries, research and development costs, and other.
Amortization and depreciation expense in this part of income statement analysis is the one you should be specifically careful about. Amortization and depreciation are like 'virtual costs', which are included in income statement with purpose of lowering profit with the purpose of reserves for replacing worn out assets. Because different accounting standards and regulations allow the use of different suggested and maximal amortization rates, accountants often find some room for manipulation of the overall company's result (profit or loss) by setting the amortization and depreciation numbers to suit their needs. They might be hiding some profit in good years if they use maximal amortization rates and use the inverse approach in bad times.
Research and development costs can be an important part or company's expenses, especially with technology companies. In most cases the long-term success of this company's depends of R&D, therefore they shouldn't be cutting them for the purpose of better final earnings result.
Financial Expenses
In the segment of analyzing financial costs, interests and taxes are crucial components. If company is financing its business with high debt than you can expect also to see high interests expense in the income statement analysis. Taxes are something companies have to pay, but accountants have some possibilities to influence on the final result on which taxes are calculated and paid.
Earnings
Earnings are calculated as revenues minus expenses. If revenues are higher than expenses, the company is generating profit. If the situation is around and the company's expenses are higher than revenues, the final result is known as loss or negative profit.
In finance many categories of earnings are used, depending on which expenses we calculate in the formula.
Gross Profit
Gross profit is calculated as revenues minus COGS. If it is expressed in percentage terms, it is known as gross margin. You should be looking for companies with the highest gross profits in industry, since they will be able to well support other parts of business. Like elsewhere in income statement analysis, trend is important factor. If gross margin is decreasing, this is not a good sign, especially if the company is operating in a business where it is difficult to pass higher expenses onto customers.
Operating Profit
Gross profit is calculated as revenues minus operating expenses, whereas some expenses are excluded out of the calculation, if they are not strictly related to company's actual operations. If it is expressed in percentage terms, it is known as operating margin. Higher operating margin than its competitors can be result of effective cost control or revenues growing faster than costs. Compare companies in the same industry and again, research the trend. Many investors believe that this number is more important than net earnings, because it is harder to manipulate it with accounting tricks.
Net profit
Net profit is calculated as revenues minus all expenses, including financial expenses. This is the final earnings figure calculated and is most common used in general conversations among people.
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Conclusion
Once again, you should put on your watch list stocks of those companies, which are increasing sales and have higher profit margins than its competitors. This usually means that this company has some kind of competitive advantage over others; it indicates company's efficiency and profitability. Companies with lower profit margins are more risky and can be wiped out of the business very quick in a downturn like the last financial crisis. If this happens, the strongest companies become even stronger, as their market share increases.
Whatever research or analysis method you use, always compare the company results with its competitors in the same industry; cross industry comparison makes no sense.
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Written by: Goran Dolenc
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