Analyzing the Income Statement - Business Management for Financial Advisers

The income statementis basically the first financial statement you will come across in an annual report or quarterlySecurities and exchange commission(SEC) filing.

It also contains the numbers most often discussed when a company announces itsresults- numbers such asrevenue, earningsandearnings per share. Basically, the income statement shows how much money the company generated (revenue), how much it spent (expenses) and the difference between the two over a certain time period.

When it comes toanalyzing fundamentals, the income statement lets investors know how well the company’s business is performing - or, basically, whether or not the company is making money. Generally speaking, companies ought to be able to bring in more money than they spend or they don’t stay in business for long. Those companies with low expenses relative to revenue - or high profits relative to revenue - signal strong fundamentals to investors.

Revenue as an investor signal

Revenue, also commonly known as sales, is generally the most straightforward part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period, although big companies sometimes break down revenue by business segment or geography.

The best way for a company to improve profitability is by increasing sales revenue. For instance, Starbucks Coffee has aggressive long-term sales growth goals that include a distribution system of 20,000 stores worldwide. Consistent sales growth has been a strong driver of Starbucks’ profitability.

The best revenue are those that continue year in and year out. Temporary increases, such as those that might result from a short-term promotion, are less valuable and should garner a lower price-to-earnings multiple for a company.

What are the Expenses?

There are many kinds of expenses, but the two most common are thecost of goods sold(COGS) andselling, general and administrative expenses(SG&A). Cost of goods sold is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company. For example, if Wal-Mart pays a supplier $4 for a box of soap, which it sells to customers for $5. When it is sold, Wal-Mart’s cost of good sold for the box of soap would be $4.

Next, costs involved in operating the business are SG&A. This category includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. SG&A also includes depreciationandamortizing.

Companies must include the cost of replacing worn out assets. Remember, some corporate expenses, such asresearch and development(R&D) at technology companies, are crucial to future growth and should not be cut, even though doing so may make for a better-looking earnings report. Finally, there are financial costs, notably taxes and interest payments, which need to be considered.

Profits = Revenue - Expenses

Profit, most simply put, is equal to total revenue minus total expenses. However, there are several commonly used profit subcategories that tell investors how the company is performing. Gross profit is calculated as revenue minus cost of sales. Returning to Wal-Mart again, the gross profit from the sale of the soap would have been $1 ($5 sales price less $4 cost of goods sold = $1 gross profit).

Companies with highgross marginswill have a lot of money left over to spend on other business operations, such as R&D or marketing. So be on the lookout for downward trends in the gross margin rate over time. This is a telltale sign of future problems facing the bottom line. When cost of goods sold rises rapidly, they are likely to lower gross profit margins - unless, of course, the company can pass these costs onto customers in the form of higher prices.

Operating profitis equal to revenues minus the cost of sales and SG&A. This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. High operating margins can mean the company has effective control of costs, or that sales are increasing faster than operating costs.

Operating profit also gives investors an opportunity to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures (which are needed to do gross margin analysis). Operating profit measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings.

Net income generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the “bottom line” and is generally the figure people refer to when they use the word "profit" or "earnings".

When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times - leaving them even better positioned when things improve again.

Income Statement

Income Statement

Common Size Financial Statement

Common Size Financial Statement

Where Is the Problem?

Where Is the Problem?

Where Is the Problem?

Where Is the Problem?

Break-Even Analysis

An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point.

Break-even analysis is a supply-side analysis; that is, it only analyzes the costs of the sales. It does not analyze how demand may be affected at different price levels. For example, if it costs $50 to produce a widget, and there are fixed costs of $1,000, the break-even point for selling the widgets would be:

If selling for $100: 20 Widgets (Calculated as 1000/(100-50)=20)
If selling for $200: 7 Widgets (Calculated as 1000/(200-50)=6.7)

In this example, if someone sells the product for a higher price, the break-even point will come faster. What the analysis does not show is that it may be easier to sell 20 widgets at $100 each than 7 widgets at $200 each. A demand-side analysis would give the seller that information.

Trend Analysis

An aspectof technical analysis that tries to predict the future movement of a stock based on past data. Trend analysis is based on the idea that what has happened in the past gives traders an idea of what will happen in the future.

There are three main types of trends: short-, intermediate- and long-term

Trend analysis tries to predict a trend like a bull market run and ride that trend until data suggestsa trend reversal (e.g. bull to bear market).Trend analysis is helpful because moving with trends, and not against them, will lead to profit for an investor.

Evaluating Return on Ownership

Unless you track your financial information, you cannot meaningfully evaluate return on ownership separately and distinctly from return on labor. Every adviser who owns and works in an advisory firm is both an employee of the business and an investor in the business and should be generating appropriate returns from both roles. If you’re an employee of the business, you should be paid market-rate compensation for doing the job—return on labor.

You should also see a return on ownership—typically in the form of a profit distribution— for the risk inherent in owning a business. When the business owner is primarily responsible for revenue generation, client advice, or relationship management, the compensation for working in the business is categorized as a direct expense. When the owner’s primary responsibilities are management or administration, compensation for working in the business is categorized as an overhead expense. In either case, compensation should be determined relative to the value of the job in the market.

One benchmark for setting a fair compensation level for the owner is to consider what the firm would have to pay someone else to come in and do that job. Of course, this solution doesn’t take into consideration the years the owner has been with the business or the sweat and tears put into building it. Those things are recognized in the return on ownership.

For compensation, we’re looking solely at the value of the job and what you would have to pay someone else to do it. Other good sources of compensation benchmarking data are available online and in your community, such as through Robert Half & Associates, local compensation consulting firms, or other sources.

Evaluating owner’s returns

Evaluating owner’s returns

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