Formulas, Calculations, and Financial Ratios for the Income Statement
A handy reference sheet for analyzing an income statement
You probably already understand the importance of financial ratios, and you've already learned the formulas for many of these metrics. Still, it can help to have an easy-to-reference summary sheet on hand. That way, whenever you are working your way through a company's financial statements and you get to the income statement, you can crunch the numbers yourself without having to refresh your memory on the most important calculations.
It can also help to break down financial ratios into five different categories, as it makes understanding their purpose easier and helps you mentally sort out what you're attempting to measure. Grouping together the ratios helps you keep the bigger picture in mind, and how the various components fit into that bigger picture. Of course, this mostly comes down to preference. 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 concepts related to an income statement, along with the equations you'll need to calculate the metrics yourself.
- Gross margin = gross profit ÷ revenue
- Research and development (R&D) to sales = R&D expense ÷ revenue
- Operating margin (also known as operating profit margin) = operating income ÷ revenue
- Interest coverage ratio = earnings before interest and taxes (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 income ÷ total average assets for the period (it can also be calculated as net profit margin X asset turnover)
Formulas for Both Balance Sheets and Income Statements
When you can analyze both an income statement and a balance sheet side-by-side, you can calculate several additional financial ratios.
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. Popularized by Warren Buffett in the '80s, a company's owner earnings is the net cash flow over the entire life of the business, minus dividends and other reinvestments into the business. The metric is 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 the method can be applied to real estate investments as well as equities.