Learning How to Analyze an Income Statement
As we continue our investing lesson series, the next subject we are going to tackle is how to analyze an income statement. My goal in writing this lesson is to:
- Teach you the structure of an income statement
- Define and explain words and concepts you are likely to encounter on income statements you study in the future
- Walk you through calculations and financial ratios that you can take from the income statement to get a better idea of the quality, condition, and economic characteristics of the business or enterprise you are analyzing
- Help you integrate the income statement with what you learned about analyzing a balance sheet in the previous lesson.
If you commit to financial statement analysis, it is a skill set that can pay dividends for the rest of your life, whether you are reading an annual report, diving into a Form 10-K filing, trying to understand the structure of a competitor, or making an investment in a small business. It can save you from financial disaster, help you spot improvements that shower you and your family with wealth, and, in some cases, achieve financial independence early in life.
What Is the Purpose of the Income Statement?
The primary purpose of any income statement is to report a company's earnings to investors and managers over a specific period of time, so they can understand how the firm is performing on a core, economic basis. In olden days, people tended to refer to the income statement as the P&L Statement, which was short for "Profit and Loss Statement."
The Limitations of the Income Statement
There is a mistake that many new investors make in assuming that the income statement is the most important financial statement. As a result, it is too often the sole source of attention as equally important considerations such as capital structure and cash flow are ignored; considerations that can make or break a firm.
After all, right up to the collapses that destroyed their stockholders, Wachovia, AIG, and Lehman Brothers looked profitable. The dangers there were buried in the footnotes, balance sheet, and cash flow statements, not the income statement so be aware of the limitations.
One of these limitations is the use of estimates. For better or worse, the income statement requires the use of certain approximations. These estimates can vary among reasonable people of good intent but they necessarily introduce an element of ambiguity in the figures. No one really knows how long a desk or computer, copy machine or corporate jet is going to last but depreciation expenses must be estimated nevertheless. (We'll get into that later in this lesson.) Banks don't know ahead of time exactly how much of their loan book is going to go bad but they need to record reserves against earnings they think are reasonable. High profile lawsuits can't be predicted ahead of time but in the event of probable losses, charges need to be made on the income statement to sit in reserves on the balance sheet. The downside is that economic reality can sometimes be obfuscated intentionally or non-intentionally. You get things like "cookie jar" accounting abuse where management overestimates reserves during good times only to reverse these charges when things get tough so they can pad the numbers and make themselves look good.
Using Income Statement Analysis to Calculate Expenses, Earnings, Financial Ratios and Profit Margins
Even with these drawbacks, income statement analysis reveals much more than a company's earnings to the serious investor or analyst. It provides important insights into how effectively management is controlling expenses, the amount of interest income and expense, and the taxes paid. Investors can use income statement analysis to calculate financial ratios that will reveal the rate of return the business is earning on the shareholders' retained earnings and assets (in other words, how well they are investing the money under their control). They can also compare a company's profits to its competitors by examining various profit margins such as the gross profit margin, operating profit margin, and net profit margin.
Beginning Our Analysis of the Income Statement
As we progress through this series of investing lessons, you must remember John Burr William’s basic truth that a business is only worth the profit that it will generate for its owners from now until doomsday, discounted back to the present, adjusted for inflation. The income statement is the “report card” of those earnings; earnings that ultimately determine the price you should be willing to pay for a business.
Sit back in your chair, take out a copy of an annual report or 10K, flip to the consolidated income statement for the most recent year, and let’s begin working through it. In the end, I think you’ll be surprised by how much you’ve learned. Towards the end of this lesson, we will actually work through Abercrombie & Fitch and Brown Safety's income statements.