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Income Statement AnalysisIntroductionThe income statement is a basic record for reporting a company's earnings. Since earnings are a fundamental component in a firm's worth, it is essential for investors to know how to analyze different elements of this important document. This section is designed to teach you some basic methods for analyzing the income statement. Analyzing income statements is an important tool to help investors appraise their investment options. By analyzing an income statement properly, investors can begin to evaluate the effectiveness of the management of operations in the companies in which they are interested in investing. Proper income sheet analysis can help identify good investment opportunities. It can also reduce the risk involved with choosing a poor investment choice. In this section, we introduce you to the following ratios, tools and concepts to help you analyze income statements:
Interest Coverage (a.k.a. Times Interest Earned)Interest Coverage is the measurement of how many times interest payments could be made with a firm's earnings before interest expenses and taxes are paid. From a bondholder's perspective, interest coverage is a test to see whether a firm could have problems making their interest payments. From an equity holder's perspective, this ratio helps to give some indication of the short-term financial health of the company. The following formula is used to determine the coverage of interest:
A higher ratio is typically better for bondholders and equity investors. For bondholders a high ratio indicates a low probability that the firm will go bankrupt in the near term. A company with a high interest coverage ratio can meet their interest obligations several times over. Stock investors typically like companies with high interest coverage ratios too. A high ratio indicates a company that is probably relatively solvent. Thus, all other things equal, an investor should be very careful with firms that have a low Interest Coverage Ratio with respect to other companies in their industry. Since the fundamental purpose of the income statement is to report profits or losses, understanding the various profitability ratios that follow is extremely helpful to your analysis of a firm.
Profitability RatiosProfitability is often measured in percentage terms in order to facilitate making comparisons of a company's financial performance against past year's performance and against the performance of other companies. When profitability is expressed as a percentage (or ratio), the new figures are called profit margins. The most common profit margins are all expressed as percentages of Net Sales. Let's look at a few of the most commonly used profit margins that you can easily learn to use to help you measure and compare firms: Gross Margin is the resulting percentage when Gross Profit is divided by Net Sales. Remember that Gross Profit is equal to Net Sales - Cost of Goods Sold. Therefore, Gross Margin represents the percentage of revenue remaining after Cost of Goods Sold is deducted. Let us take a look at a simple example.
In this example the Gross Margin = 600/1000 = .60 or 60% Since this ratio only takes into account sales and variable costs (costs of goods sold), this ratio is a good indicator of a firm's efficiency in producing and distributing its products. A firm with a ratio superior to the industry average demonstrates superior efficiency in its production processes. The higher the ratio, the higher the efficiency of the production process. Investors tend to favor companies that are more efficient. Operating Margin. As the name implies, operating margin is the resulting ratio when Operating Income is divided by Net Sales.
This ratio measures the quality of a firm's operations. A firm with a high operating margin in relation to the industry average has operations that are more efficient. Typically, to achieve this result, the company must have lower fixed costs, a better gross margin, or a combination of the two. At any rate, companies that are more efficient than their competitors in their core operations have a distinct advantage. Efficiency is good. Advantages are even better. Most investors will tend to prefer a more efficient company. Let's move on to the last profitability measure we will cover in this section. Net Margin. As the name implies, Net Margin is a measure of profitability for the sum of a firm's operations. It is equal to Net Profit divided by Net Sales:
As with the other ratios you will want to compare Net margin with other companies in the industry. You can also track year-to-year changes in net margin to see if a company's competitive position is improving, or getting worse. The higher the net margin relative to the industry (or relative to past years), the better. Often a high net margin indicates that the company you are looking at is an efficient producer in a dominant position within its industry. However, as with all the previous profit margin measurements, you need to always check past years of performance. You want to make sure that good results are not a "fluke." Strong profit margins that are sustainable indicate that a company has been able to consistently outperform their competitors. The saavy investor uses profitability margins to help analyze income statements of prospective investments. Companies with high interest coverage ratios, gross margins, operating margins and net margins will always be very attractive to investors.
Where Did All Those Expenses Come From?You have just finished learning about interest coverage and profitability ratios. Both of these measures are simple and easy to understand. Interest coverage measures a company's ability to make its loan payments. Profitability ratios measure the bottom line of the income statement - earnings. However, to calculate either ratio, you must be able to classify a company's expenses. The interest coverage ratio concerns itself with a specific type of expense (interest expense). Meanwhile, profitability ratios such as net profit margin consider the net effect of all the expenses a company incurs. Most of the expenses a company incurs (raw materials, labor, rent, etc.) are straightforward items. In general, companies want to minimize these sorts of expenditures to ensure improved performance and profitability. For example, the less a company has to pay for the raw materials of the products it produces, the more competitive that company can become. Yet, there is one type of expense companies cannot eliminate. In fact, incurring this expense actually helps save the company money. What is this mysterious expense?
Depreciation ExpenseDepreciation 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. 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. Like all other expenses, depreciation expense reduces the taxable income of the company. Yet, a business reporting a depreciation expense incurs no additional cash expenditure. Simply put, depreciation allows businesses to reduce their taxable income without making the additional cash expenditure typical of most other expenses. While depreciation is an attractive way to reduce taxable income, specific regulations govern how it is to be calculated and allocated. Let's take a moment to review a few important points about how companies calculate depreciation.
Basic Points about Calculating DepreciationWhen analyzing income statements, it is very important to understand how different accounting methods for calculating depreciation affect the income statement. Sometimes the accounting methods selected can materially alter the net result of this important statement. Most businesses have the right to choose amongst a number of different depreciation schedules. Typically, businesses elect a depreciation schedule to suit their specific needs or preferences. In order to make comparisons of different companies, you will need to know the role that accounting plays in the final composition of their respective income statements. A company can choose from several methods (or depreciation schedules) to calculate its depreciation expense. Read below to look at two of the most common methods.
Straight-Line DepreciationStraight-line Depreciation is the simplest and most commonly used accounting method for depreciation. Basically, the straight-line depreciation method calculates the amount of annual depreciation expense that is to be recorded by dividing the value of the asset (as determined by its purchased price) by its useful life. Often some adjustment is made for the anticipated "residual value" that the asset may have at the end of its "useful life." The IRS provides taxpayers with a depreciation schedule that defines what the useful life of different types of assets (cars, computers, etc.) are to be. Thus, an item that has a relatively short-lived useful life (such as a computer) may be able to be depreciated more quickly than an asset (such as a building) that has a long and useful life expectancy ahead of it. Using a straight-line depreciation schedule, businesses deduct the same amount of depreciation each year until the assets has been fully depreciated. However, straight-line depreciation is not the only method available. Let's look at another popular option.
Accelerated Depreciation MethodsAccelerated Depreciation Methods are also a very common way for companies to allocate their depreciation expenses. These methods are those methods that are utilized to write off depreciation costs more rapidly than the straight-line method. Various accelerated methods exist. Two popular methods of accelerated depreciation are Sum-of-the-Years'-Digits and Double Declining Balance. These methods are more complex in nature and we will not delve into their calculations at present. However, the important thing to know is that each of these methods record depreciation expense more heavily in the current years in comparison to the straight-line method. By recording more expense in the early stages of an assets useful life, accelerated depreciation methods reduce the taxable income for those years and thus reduce income taxes for those years. However, in later years, accelerated depreciation methods will record less depreciation, leaving more income. The company will therefore have to pay greater taxes.
Selecting a Depreciation MethodFor the company, the choice of depreciation method will depend on a company's current financial situation and/or its own preferences. Companies that wish to defer current taxable income may elect accelerated depreciation methods to accomplish this goal. However, companies that need to show large earnings in the current year may elect to forgo accelerated depreciation methods and opt for a straight-line method. Both methods have their advantages and disadvantages. Typically, a company is free to choose the method that best suits its preferences. However, as an investor, you will likely not have the power to tell the company what method to use. Instead you will need to know how each of these different methods can alter an income statement. If you can do this, you will be able to evaluate how a company's depreciation schedule impacts the value of the investment opportunity. When making comparisons of different companies, you should always check to see if they use the same accounting methods. If not, you will want to make an adjustment in order to effectively compare these companies. At first, comparing depreciation methods and accounting rules may seem daunting. However, with a little practice you will be armed and ready to really understand the companies you are interested in investing in. Concluding RemarksNow that you have completed this section, you should be familiar with some basic methods to help you evaluate different investment options. Using the analysis techniques that we have introduced, you have a good basis of knowledge from which to make informed investment decisions. Remember that the main purpose of the income statement is to report profitability. Because profitability is crucial in any investment decision, knowing some basic techniques of how to analyze the income statement should be a very important part in your development as an informed investor.
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