Income Statement Basics
An income statement shows the amount of money a company takes in, the expenses of the company, and the net earnings (also know as net profit, net income, or just plain earnings) of the company over a specific period of time. The net income or net earnings is the amount of money the company has left after paying its expenses and its taxes.
The table below, is the Income Statement for Ford Motor Company with some data from an old income statement. We will use this income statement to explain the components of most corporate income statements.
We have broken the income statement down into six main categories:
Total Sales (line #1): the amount of money taken in by the company when it sells its product (cars in this case).
Cost of sales (line #2): how much it cost to make the products (cars in this case).
Expenses ( lines #3 to #6): how much it costs to cover the expenses such as leases, telephone expenses, interest on loans, and income tax owed to the IRS.
Other Expenses (line #7): Unusual or non-recurring expenses.
Other Income (line #8): Unusual and non-recurring income (for example, money made by selling a building, etc).
Net Income or Net Earnings (line #9): the amount that is left when the company adds up all the money it takes in and subtracts all its expenses. In general, investors look at the growth of Net Earnings as it relates to the amount of shares in the company.
Earnings Released By Corporations
Corporations usually release their earnings for each three-month interval during its fiscal year. These are called quarterly earnings. A fiscal year is the one-year period in which the company measures its performance. This period can be from January 1 to December 31 or any other one-year period such as from February 1 to January 31. In fact a company can define its fiscal year as beginning in any month and ending twelve months later.
A company that has its fiscal year beginning on January 1 will release quarterly earnings for the following periods: January 1 to March 31, April 1 to June 30, July 1 to September 30, and October 1 to December 31. On the other hand, a company with a fiscal year that begins on February 1 will release quarterly earnings for the following periods: February 1 to April 30, May 1 to July 31, August 1 to October 30, and November 1 to January 31.
Stock analysts compare earnings from one quarter to the corresponding previous year's quarter. This type of comparison is reasonable because some businesses are seasonal. That is, sales in some quarters are bigger than in others.
This practice is justified with retail stores because many of them make 30% to 40% of their year's sales during the Christmas holiday season. It makes perfect sense for these stores to compare sales of one Christmas season with the previous Christmas season.
What The Income Statement Reveals
The income statement can reveal a lot of information that investors can use to make decisions on what stocks to buy. The following passages will get you started in exploring income statements.
Earnings Per Share
One very important figure most investors look at is how much profit each shareholder makes for each dollar he or she invests. This is usually called earnings per share and it is calculated by dividing after-tax earnings by the number of shares issued by the company. The 2005 full-year earnings per share for International Business Machines Corporation (IBM) and the McDonald's Corporation were $4.92 and $2.04, respectively. These companies have a lot of shares outstanding. Ford Motor Company, for example, had 1.88 billion shares in the hands of investors (in May 2006). An earnings per share, or EPS as it's commonly called, is more meaningful when you look at EPS growth from period to period and when you compare it with the EPS of other companies in the same line of business.
Net Profit Margin
In addition to EPS, another way to measure how profitable a company was in any given year is through its net profit margin (also known as profit margin). Net profit margin is a company's net earnings divided by its total revenue. Net profit margin tells you how much of a companies sales it actually keeps. For Ford, which had sales of $177.1 billion and a profit of $2.0 billion in 2005, the net profit margin is calculated as follows:
Ford Net Profit Margin In '05 = $2.0 billion / $177.1 billion = 1.1%
This number is useful only when you compare it to the net profit margin of the same company in prior years or you compare it to the net profit margin of other companies in the same business. Big corporations generally have small net profit margins. This is always a big surprise to Teenvestors who, like most people, think that companies keep a lot more money than they do.
Dividends and Retained Earnings
After a company determines how much money it has made during the year, it has to decide what to do with that money. It can do basically two things with the money: pay it all to its shareholders or plow it back into the company to buy equipment or expand the business. The biggest companies in America such as IBM and McDonald's often pay some of the profits to shareholders as dividends and also to keep some of the money in the company. The money kept in the company is called retained earnings and you will find it under the equity section of the balance sheet. You can think of retained earnings as additional equity that the owners of the company have contributed to the business.
The Dividend Yield
The dividend yield, the ratio of the dividend per share to the price of each share, is another frequently watched figure in the stock-picking game.
Most companies pay out a fixed dollar amount of dividends per share from year to year, with occasional adjustments. For many investors, dividend yield is important because it provides them with a steady source of income above the possible appreciated value of the stock. But when you think about it, a high dividend yield could mean that the share price has gone down which could mean a loss to you when it is time to sell. For example, buying stock based on dividend yield can also be faulty because companies that are not doing well can easily cut or eliminate their dividends. The lesson here is that dividend yields can vary greatly because they depend on share prices and the economic conditions that companies are facing.
The stocks of stable, well-established companies that have paid dividends to investors over a long period of time and that are no longer growing at a fast pace are known as blue-chip stocks. When Teenvestors begin investing, they should start with shares in these types of companies. However, as they gain more experience as investors, we also recommend that they gradually buy shares in faster growing companies that pay no dividends but instead, plow all their profits back into the company to help the company thrive. The stocks of these types of companies are known as growth stocks.