Five Tips for Analyzing an Income Statement

Home
>
Business Management
>
Five Tips for Analyzing an Income Statement

Five Tips for Analyzing an Income Statement

In today's article, we'll be looking at the income statement, which is the most deceptively simple of the major financial statements. I say simple because it's just a list of all the revenue, minus all the expenses, to calculate what's left over in profit. It's no more difficult than putting your family budget together, right?

That's where the deceptive part of the description comes in. The items on the income statement are easily manipulated by, say, less-than-honest management, and don't necessarily represent the true situation at a company. Even totally honest companies can have income statements that don't represent economic reality. Cash flows define economic reality, revenue and expenses define accounting reality.

You see, the difference between your household budget and a company's income statement is their relationships to actual cash flows. Your household budget will generally match your cash inflows and outflows. Not so with an income statement. Income statements can vary significantly from the company's cash flow, meaning that a company in economic trouble can show a very "good" income statement up until the day it goes bankrupt.

Generally speaking, though, the income statement is a good place to start when evaluating a company. In my forthcoming e-book, Fundamentals of Financial Statement Analysis, I lay out the process for evaluating the health of a company through the financial statements. I'm shooting for publication in the beginning of 2004, but in the meantime, here are some tips and strategies for evaluating an income statement.

1. Create a Common Size Statement

What's a common size statement, you ask? It's the income statement, only with each line item represented as a percentage of sales. This is easy to do with a spreadsheet on your computer, but you can do it on paper just as well. Net Sales is always 100% at the top, and each of the expenses is divided by total sales to arrive at a percentage. For example, if a company has $100 in sales and $50 in cost of goods sold, the common size statement will look like this:

Sales 100%

Cost of Goods Sold 50%

Gross Profit 50%

The importance of the common size statement can't be overstated. It gives you the calculation of all your profit margins, from gross to net, and shows how much each cost item takes away from your profits.

2. Create a Year-to-Year Comparison Statement

The next step is to make a year-to-year comparison statement. You can't evaluate financial statements for just a single year; they have to be compared to previous years. The only formula you need to know for these calculations is:

(current year / previous year) ? 1 = % change

Again, a spreadsheet makes this process so much easier, but it can be done by hand. I like to have five years of data, which yields four years of comparison data. This way you aren't just looking at an exceptionally good or bad year for the analysis. Plus, you can get a reasonable estimate of future growth when you do your discounted cash flow analysis. (I'll have more on the Discounted Cash Flow in the future.)

3. Read the Management Discussion and Analysis

If you take the time to read the MD&A, you'll have an advantage on most investors. A majority of individual investors simply skip this part, and go right to calculating ratios or looking at the EPS. Seasoned investors know that the MD&A provides the backup data for the income statement line items, and they will take time to read it.

A good Management Discussion and Analysis will give you the details you need to understand the items on the income statement. You should get segmented sales data, cost drivers, etc. in this section. If you can't make sense of the MD&A, that should set off alarm bells in your head. If you don't find the information you need in the MD&A, you should?

4. Look at the Notes to Consolidated Financial Statements (Footnotes)

The footnotes tend to be more difficult to understand than the MD&A, but you get really detailed information here. The footnotes are where management hides the dirty laundry. And when you've got guys making today's corporate salaries that laundry pile can get pretty big. Here's where you'll likely find what you couldn't in the MD&A, it's just that in the notes you may have to do some putting of two and two together.

Take your time sifting through this section, and try to identify the income statement items that relate to the footnotes you're reading. You can do it the other way around, as well, and look for the footnotes that relate to the income statement item.

If you still can't figure out what the company is doing, after going through the MD&A and the footnotes, you may want to consider looking at another company. This one may be too complicated (or too devious) for your abilities. Don't feel bad about not understanding the business, either. Even the great Warren Buffett admits that he doesn't understand some businesses, and he never lets his ego run away from him. If he can't understand it, he won't invest in it. I recommend you do the same thing.

5. Look at segmented data

I always like to look at segmented sales and profit figures to determine which product lines, or operating businesses, are growing sales faster than the others. This information is usually in the MD&A. If you can, try to find the operating profit for each business segment as well. Then look at the profit margins for each segment of the business.

You may be surprised at the different profitability levels of each business segment. Compare the segment with the fastest growing sales versus the segment with the highest operating profit. If these are the same segment, that's good news. If they aren't, that's okay too.

You do want to watch out for companies that have the lowest operating profit in their fastest growing segment. This could cause a decline in the company's overall profitability as sales grow faster than profits. For example, a segment that's growing 5% a year, but has a 10% margin, will contribute more to total operating profit growth than a segment growing at 20% a year with a 1% margin.

I hope you find these tips helpful. Of course, there are plenty of other analysis tools that you can use to evaluate financial statements. It's important that you keep looking for more and better ways to analyze company data, because constant learning will make you a consistently better investor.

About The Author

Chris Mallon is the editor and publisher of the Undervalued Weekly, a free personal finance and investment newsletter dedicated to creating smarter investors.

To sign up for the Undervalued Weekly, send e-mail to underval@hot-response.com, or sign-up through the website at www.dynamicinvestors.net/index7.html; chrismallon@dynamicinvestors.net

In The News:

Yahoo! News: Top Stories

Key panel recommends impeaching Ill. governor (AP)

AP - A key panel unanimously recommended impeachment for Gov. Rod Blagojevich on Thursday, setting up a vote that could make him the first governor to face such fate in Illinois' sordid political history. Blagojevich should lose his job for abusing power, mismanaging government and committing possible criminal acts, including federal allegations he tried to sell off a U.S. Senate seat, the special committee concluded.

Cheney: CIA did nothing illegal in interrogations (AP)

AP - Vice President Dick Cheney said Thursday that he sees no reason for President George W. Bush to pre-emptively pardon anyone at the CIA involved in harsh interrogations of suspected terrorists. "I don't have any reason to believe that anybody in the agency did anything illegal," he said.

UN halts Gaza aid as deal OK'd on truce resolution (AP)

AP - The U.N. suspended food deliveries to Gaza and the Red Cross accused Israel of blocking medical assistance after forces fired on aid workers, killing two, as the threat of a wider conflict emerged with Lebanon. With violence unabated in Gaza, key Arab nations and Western powers reached an agreement Thursday on a proposed U.N. resolution calling for an immediate and durable cease-fire between the two sides and moved for a vote late Thursday night.

Democrats criticize Obama's proposed tax cuts (AP)

AP - President-elect Barack Obama's proposed tax cuts ran into opposition Thursday from senators in his own party who said they wouldn't do much to stimulate the economy or create jobs. Senators from both parties agreed that Congress should do something to stimulate the economy. But Democratic senators emerging from a private meeting of the Senate Finance Committee criticized business and individual tax cuts in Obama's stimulus plan.

Obama: Congress must act boldly and now on economy (AP)

AP - President-elect Barack Obama implored Congress on Thursday to "act boldly and act now" to fix an economy growing perilously weaker. Leading lawmakers set an informal goal of mid-February for enacting tax cuts and government spending that could cost as much as $1 trillion.

Madoff 'victims' do math, realize they profited (AP)

AP - The many Bernard Madoff investors who withdrew money from their accounts over the years are now wrestling with an ethical and legal quandary.

Fatal police shooting sparks violent protests (AP)

AP - In grainy cell-phone videos played over and over on the Internet, police officers force an unarmed black man to the ground and hold him face-down on a crowded train platform. Suddenly one of the officers draws his gun and fatally shoots the man in the back then looks up.

Court papers: Gotti neighbor was dissolved in acid (AP)

AP - It is perhaps the most intriguing unsolved mystery from the gaudy gangland career of John Gotti: Whatever happened to the neighbor who accidentally ran over and killed the mobster's 12-year-old son and then vanished?

Man allegedly caused flats with nails in driveways (AP)

AP - Police in upstate New York say a man has been sprinkling roofing nails on the driveways of people he didn't like to cause flat tires for two years. Stony Point police Lt. Peter Quinn said Michael Delisio was arrested Tuesday after an officer staking out one victim's home saw nails being thrown from Delisio's car.

Florida, Oklahoma play for college football crown (AP)

AP - The Oklahoma Sooners and the Florida Gators meet tonight for the BCS championship. It's a matchup that includes a pair of Heisman Trophy winners, an SEC vs. Big 12 debate and more than its share of trash talk.

Israel faces criticism as Gaza toll hits 765 (Reuters)

Reuters - Recovery teams ventured into battlegrounds of the Gaza Strip on Thursday to gather bodies from the rubble, and Hamas officials said the Palestinian death toll in Israel's 13-day-old offensive had risen to 765.

Obama pushes stimulus, warns on recession (Reuters)

Reuters - President-elect Barack Obama warned on Thursday the U.S. economy could stay mired in recession for years without bold action and he urged lawmakers to work day and night to pass a massive stimulus plan.

Citi backs measure to help avoid foreclosures (Reuters)

Reuters - Financial giant Citigroup Inc will support a proposal in Congress to rewrite U.S. bankruptcy law to help troubled mortgage borrowers avoid foreclosure, Chief Executive Vikram Pandit said on Thursday.

U.S., Iran share interests in Afghanistan: Petraeus (Reuters)

Reuters - The United States and its allies share some interests with Iran when it comes to stabilizing Afghanistan, Army Gen. David Petraeus, head of the U.S. military's Central Command, said on Thursday.

Illinois panel recommends governor's impeachment (Reuters)

Reuters - A legislative committee on Thursday recommended the impeachment of Illinois Gov. Rod Blagojevich, citing widespread abuse of power including allegations he tried to sell the U.S. Senate seat vacated by President-elect Barack Obama.

Madoff had $173 million in checks ready, U.S. says (Reuters)

Reuters - Accused swindler Bernard Madoff had signed checks totaling more than $173 million in his office desk ready to be sent out before his arrest, U.S. prosecutors said in court papers on Thursday asking a judge to jail him.

Obama names Virginia gov as Democratic Party head (Reuters)

Reuters - President-elect Barack Obama named Tim Kaine as head of the Democratic Party on Thursday, rewarding an early supporter with a high-profile political post even as he continues to serve as Virginia governor.

Wal-Mart and other U.S. retailers warn after dismal holiday (Reuters)

Reuters - Wal-Mart Stores Inc and other top U.S. retailers delivered disappointing December same-store sales and profit warnings on Thursday, sparking fresh recession concerns that hit stock and currency markets.

Diplomats push for Gaza ceasefire as UN agency halts work (AFP)

AFP - Diplomatic efforts to end the Gaza conflict intensified Friday with Western and Arab diplomats agreeing to call for an immediate ceasefire as the death toll from the two-week-old war rose past 760.

EU announces breakthrough in Russia-Ukraine gas dispute (AFP)

AFP - Russian Prime Minister Vladimir Putin agreed Thursday on the terms for the deployment of gas monitors in Ukraine, paving the way for an end to a Europe-wide energy crisis, the EU presidency said.

Five Tips for Analyzing an Income Statement

Business Management Business Management