Formulas, Calculations and Financial Ratios for the Income Statement
Investing Lesson 4 - Analyzing an Income Statement
Congratulations! You've learned how to analyze an income statement! Now, I want to talk about financial ratios and calculations. While you already know that financial ratios are important, and you've learned how to calculate many different financial ratios from the income statement by this point in the investing lesson, I wanted to create an easy-to-reference summary sheet for you to keep. That way, whenever you are working your way through a company's financial statements and you get to the income statement, you can begin doing the calculations yourself by having it written on a scrap of paper or in a notebook.
Before you begin to compose your list of financial ratios, one recommendation I'd make is to organize your them by category. Usually, I break down financial ratios into five different categories as I believe it makes understanding their purpose easier and helps you sort what you're attempting to measure in your head; a way to get a bigger, better picture of how the various components fit together. As you improve your skills and become more familiar with accounting and finance, you'll start developing your own mental framework.
Income Statement Formulas, Calculations, and Financial Ratios
Below is a list of the things you have learned in this lesson if you followed it step-by-step.
- Gross Margin = gross profit ÷ revenue
- R&D to Sales = R&D expense ÷ revenue
- Operating Margin = operating income ÷ revenue (also known as operating profit margin)
- Interest Coverage Ratio = EBIT ÷ interest expense
- Net Profit Margin = net income (after taxes) ÷ revenue
- Return on Equity (ROE) = net profit ÷ average shareholder equity for the period
- Asset Turnover = revenue ÷ average assets for the period
- Return on Assets = Net profit margin * asset turnover or net income ÷ total average assets for the period
In addition, you learned several financial ratios that required calculations discussed in Investing Lesson 3: Analyzing a Balance Sheet, which cannot be performed unless you have both the income statement and balance sheet in front of you.
- Working Capital per Dollar of Sales = working Capital ÷ total Sales
- Receivable Turnover = net credit sales ÷ average net receivables for the period
- Inventory Turnover = cost of goods sold ÷ average inventory for the period
Of course, these financial ratios are only the start; a beginner's guide to basic financial analysis. The ultimate goal is to get to the point you can calculate something known as owner earnings. That is what I am looking for in my own life when I acquire a productive asset as well as the thing I am searching for in our asset management company, Kennon-Green & Co., for private clients who want to invest alongside my family. That metric is really attempting to answer the question, "If I owned this asset, how much cash could I extract from it after taking care of necessary expenses, taxes, and maintenance capital expenditures required to keep unit volume steady without harming the competitive position of the enterprise?". When you take an owner earnings approach to income statement analysis, you need all three financial statements together - balance sheet, income statement, and cash flow statements - as well as the ability to discount cash flows to come up with a net present value.
The objective is then to pay a fair or reasonable price for the business with a heavy emphasis on companies that appear to be both quantitatively and qualitatively higher in quality. That's the end game. That's the ultimate prize for a financial analyst and, in actuality, can be applied to real estate investments as well as equities.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.