The Basics of Income Statement Analysis
Understanding income statement analysis can give you an investing skill set that pays dividends. With it, you can enhance your understanding of a company's annual report or Form 10-K filing, visualize a competitor's business structure, or learn the information you need to invest in a small business.
Understanding the Income Statement
An income statement will show you a company's profit and loss over a specific time. These statements were once more commonly known as Profit and Loss (or P&L) statements.
An income statement will typically show:
- Revenue or sales
- Cost of goods sold (COGS)
- Gross profit
- Earnings before tax
- Net earnings
Revenue or sales is the money a company takes in; subtract the cost of goods sold to find the gross profit. From gross profit, subtract expenses, arriving at earnings before tax (EBT). Expenses might include marketing, advertising, promotion, general and administrative costs, interest expense, and depreciation and amortization, which spread out the cost of assets (such as real estate or equipment) over time. Subtract the amount of taxes from EBT to calculate a company's net income or loss.
These numbers can be used in a variety of ways to gain insight into a company's financial health.
Income Statement Analysis
Investors can use income statement analysis to calculate financial ratios that can be used to compare the same company year over year, or to compare one company to another.
For example, you can compare one company's profits to its competitors' by examining its gross profit margin, operating profit margin, and net profit margin. Or you could compare one company's earnings per share (EPS) to another's, showing what a shareholder would receive per share if each company distributed its net income.
Analyzing each line up and down the statement as a proportion of the top line, which is revenue, is known as vertical analysis. It can be used to show the relative size of different expenses, for example. Horizontal analysis, on the other hand, compares the same figure across two or more periods and is useful for spotting trends. Use horizontal analysis to show year-over-year changes in a particular line item—earnings before tax for the last three years, for example.
Limitations of Income Statements
Because income statements have a few limitations, they may not always be the most important financial statement to consider. Capital structure and cash flow are also considerations—ones that can make or break a firm. Another limitation of income statements is the use of estimates.
For example, companies must estimate the depreciation of their assets; after all, they can't know ahead of time how long a computer, copy machine, or corporate jet is going to last. Or if they're facing a lawsuit, they will need to estimate how much to keep in reserve to cover their liability. By their nature, estimates can leave room for interpretation.
Another limitation of income statements is intentional over or underestimation of numbers. Although estimates are necessary, and misrepresentations can happen accidentally, they can also happen on purpose—to fraudulently increase or decrease numbers such as revenues or profits.
Finally, accounting rules can be limiting, too. When comparing income statements, remember that some companies may use first-in-first-out (FIFO) to measure inventory, while others could be using last-in-first-out (LIFO). This can affect the numbers used for comparison.