Analysis of Income Statement

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<p>Investing Lesson 4: Income Statement AnalysisIntroductionPurpose 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&amp;L) statement, and has since evolved into the most well-known and widely used financial report on Wall Street. 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 a serious 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 (in other words, how well they are investing the money under their control). 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 John Burr Williams 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 or 10K, flip to the consolidated income statement for the most recent year, and lets begin working through it. In the end, I think youll be surprised by how much youve learned. Towards the end of this lesson, we will actually work through Abercrombie &amp; and Brown Safety's income statements. As always, there will be quiz following the lesson. You should be able to pass without missing more than two questions.</p> <p>Sample Income StatementThe best way to learn to read an income statement is to begin by looking at a real world example. In this case, I'm going to take an old income statement from Microsoft because it is relatively simple, enough time has passed for us to look at the figures in retrospect, and you can look at it to get an idea of what an ordinary income statement looks like. You can see this sample at the bottom of this page. You may want to print it for reference as you work your through this lesson. It's important to note that not all income statements look alike, although they necessarily contain much of the same information. As we work our way through various income statements, you will inevitably find they are much simpler and comparable than may appear at first glance.</p> <p>Sample Income Statement Microsoft Income Statement Fiscal year Total Revenue Cost of Goods Revenue Gross Profit Operating Expense Research and Development Selling, General, and Administrative Expenses Non Recurring Other Operating Expenses Operating Income Operating Income Total Other Income and Expenses Net Earnings Before Interest and Taxes Interest Expense Income Before Taxes Income Tax Expense Equity Earnings or Loss Unconsolidated Subsidiary Minority Interest Net Income from Continuing Operations Nonrecurring Events Discontinued Operations Extraordinary Items Effect of Accounting Changes Other Items Net Income N/A N/A N/A N/A $7,829,000,000 N/A N/A ($375,000,000) N/A $7,346,000,000 N/A N/A N/A N/A $9,421,000,000 $11,910,000,000 ($397,000,000) $11,513,000,000 N/A $11,513,000,000 $3,684,000,000 N/A N/A $7,829,000,000 $11,720,000,000 ($195,000,000) $11,525,000,000 N/A $11,525,000,000 $3,804,000,000 N/A N/A $7,721,000,000 $10,937,000,000 $3,338,000,000 $14,275,000,000 N/A $14,275,000,000 $4,854,000,000 N/A N/A $9,421,000,000 $4,307,000,000 $6,957,000,000 N/A N/A $4,379,000,000 $5,742,000,000 N/A N/A $3,775,000,000 $5,242,000,000 N/A N/A 2001 2000 1999</p> <p>$28,365,000,000 $$25,296,000,000 $$22,956,000,000 $5,191,000,000 $23,174,000,000 $3,455,000,000 $21,841,000,000 $3,002,000,000 $$19,954,000,000</p> <p>Total Revenue or Total SalesTotal 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 $10 each, you would record $100 of revenue regardless of your profit or loss.</p> <p>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 (see Table STAR-1 at the bottom of this page). As you see in the chart, sales at Starbucks 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 coffee, you are adding $3 to $5 in revenue to the company's books. "Specialty" operations, on the other hand, consists of 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 or catalog, along with licensing fees generated by companies such as Barnes and Nobles, which pay for the right to operate Starbucks locations in their bookstores.</p> <p>Cost of Goods Sold - COGSCost of Revenue, Cost of Sales, Cost of Goods Sold (COGS) Cost of goods sold (COGS 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 (COGS) is also known as cost of revenue or cost of sales. Going back to our pizza parlor example, your cost of goods sold (COGS) include the amount of money you spent purchasing items such as flour and tomato sauce. The cost of goods sold per dollar of sales is going to be different depending upon the type of business you own or in which you buy shares of stock. A licensing company or law firm will have virtually no cost of goods sold because they are selling a service and not a tangible product. Before you invest in a business, you'll want to research the industry you are examining and find out what is considered "good". For corporations that drill for oil, for instance, one of the most important figures you need to consider is the cost per barrel to get the oil out of the ground. This is, in effect, the cost of goods sold for the oil company. If one firm can get crude at far lower costs than its competitors, it has a distinct advantage and will result in more profit flowing to the owners or shareholders. Another thing you want to try and figure out is how exposed a company is to a particular input cost. For Southwest Airlines, the cost of jet fuel (and thus, oil) is the most important cost the company has. For Starbucks or Folgers, now a division of J.M. Smucker's, it's coffee. For Coca-Cola, sugar prices are extremely important. One of the reasons some investors are extremely successful is because they know the exact relationship between profits and cost of goods sold. It's been noted that Warren Buffett knows the per 12 ounce can profitability figures for a serving of Coca-Cola and watches sugar prices regularly. If you were a small candy company, or even a giant like Coke, periods of time such as April to July of 2009 would have been hard for your business as sugar prices nearly doubled without warning. As an investor, you need to be aware of the risk a business faces due to unexpected higher cost of goods sold regardless of if you are buying shares of stock, purchasing a local business, or launching your own start-up.</p> <p>Gross ProfitGross Profit The gross profit is the total revenue subtracted by the cost of generating that revenue. In other words, gross profit is sales minus cost of goods sold. It tells you how much money a business would have made if it didnt pay any other expenses such as salary, income taxes, office supplies, electricity, water, rent, etc. When you look at an income statement, GAAP rules require that gross profit be broken out and clearly labeled as its own line so you can't miss it. Still, you should know how to calculate it for yourself so here is the formula: 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 in a moment. In fact, you can't really look at gross profit on its own and know if it is "good" or "bad", making the gross margin even that much more important. An Example of Gross Profit from One of My Companies</p> <p>To help illustrate the concept of gross profit, I'll give you an example from one of the businesses in which I have a substantial ownership stake. The company is called Kennon Home Accessories. It sells a lot of luxury shaving sets both online and through its flagship retail store just north of Kansas City. If a customer purchases an imported British luxury shaving set for $315, our cost of goods sold would typically be $160 for the set itself, $20 for various merchant fees, service charges, and bank processing costs, and $20 for shipping and handling into our retail store. This results in revenue of $315 - cost of goods sold of roughly $200 for a gross profit of $115 per every shaving set sold. If we were to drop the price 20% for a sale, the calculation would change to $252 revenue - $200 costs of goods sold = $52 gross profit. The $115 in the first case, or the $52 in the second, is the money we have available to pay our sales associates, taxes, office supply expense, and computer costs. The higher the gross profit, the more money we have for expansion, salaries, or dividends to shareholders.</p> <p>Calculating Gross Profit MarginGross Profit Margin Although we are only a few lines into the income statement, we can already calculate our first financial 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 Total Revenue Calculating Sample Gross Profit Margin</p> <p>For illustration purposes, let's calculate the gross profit margin of Greenwich Golf Supply (a fictional company) using its income statement. You will find the statement at the bottom of this page in Table GGS-1. Assume the average golf supply company has a gross margin of 30%. (You can find this sort of industry-wide information in various financial publications, online finance sites such as moneycentral.com, or rating agencies such as Standard and Poors). We can take the numbers from Greenwich Golf Supply's income statement and plug them into our formula: $162,084 gross profit $405,209 total revenue = 0.40 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. Gross Profit Margin Over Time 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. For more information on warning signs of accounting fraud, I recommend Howard Schilit's Financial Shenanigans: 2nd edition: How to Detect Accounting Gimmicks and Fraud in Financial Reports. Table GGS-1 Greenwich Golf Supply Consolidated Statement of Earnings - Excerpt In thousands except earnings per share Fiscal year ended Total Revenue Cost of Sales Gross Profit Sept 30, 2007 Oct 1, 2008 $405,209 $243,125 $162,084 $315,000 $189,000 $126,000</p> <p>First Three Lines of the Income StatementPutting It Together Thus Far: We've actually covered a lot of ground. Here's an example to help reiterate and clarify everything we've discussed about the income statement. If the owner of an ice cream parlor purchased 10 gallons of vanilla ice cream for $2 per gallon, and sold each of those gallons to her customers for $5, the first three lines on her income statement would look something like this:</p> <p>Total Revenue $50 (The total revenue is the amount of money rung up at the cash register. The owner sold 10 gallons of vanilla ice cream to her customers for $5 per gallon. 10 gallons x $5 a gallon = $50.) Cost of Goods Sold $20 (The cost of goods sold was 10 gallons x $2 per gallon = $20) Gross Profit $30 (The total revenue subtracted by the cost to earn that revenue is $30. Before taxes, and other expenses, this is the ice cream parlor's gross profit.) Gross Margin: .6 (or 60%) The gross margin of 60% means that for every $1 the company generates in sales, it is going to be left with $0.60. That sixty cents must be enough to cover all of the other expenses such as payroll, rent, taxes, freezers, cash registers, aprons, security systems, and accounting fees, just to name a few, before the owner will receive any dividend income from the business. Those other expenses are known as operating expenses and that's what we're going to examine on the next page.</p> <p>Operating Expense on the Income StatementOperating Expense The next section of the income statement focuses on the operating expenses that ar...</p>