Every business has 3 sets of financial statements: Income Statement, Balance Sheet and Cash Flow Statement. Learning how to read an income statement is perhaps the most important skill one needs to have when it comes to investing.
Similar to how a doctor can pinpoint issues or potential issues by looking at an X-ray report, an investor should also be able to tell whether a company is healthy or weak by looking at the numbers.
This would be a three-part beginner series that goes into the details and know-how of how to read each financial statement.
My major is in accounting and I am writing this with the aim to help beginners become financially savvy and get started with investing.
By the end of this three-part series, you will be equipped with the skillsets to read a basic financial statement.
With enough practice, you would be able to evaluate a company’s financial status and make your own call in whether stock XYZ is a good or bad investment.
1. What is an Income Statement?
The income statement simply records how much revenue the company made, how much expenses are being spent and what is their net profits within a specified period of time.
To illustrate, I have come up with a sample income statement to work with. Let’s say company XYZ sells leather wallets. Company XYZ has a headquarter office for corporate functions and a production factory that makes the wallet.
This is a very simple basic structure of how an income statement would look like.
Usually, the top-line item starts with revenue. This is the money earned by selling goods or services to customers. In this case, it would be the money earned from selling leather wallets at the retail price.
Cost of Goods Sold (COGs)
However, there is a cost incurred to produce the goods that we sold. For instance, material costs to make the wallets, labour workers to stitch the design or machines to mass-produce the wallets.
Any costs that are directly or indirectly associated with the production of the wallets are considered as cost of goods sold or COGs.
Gross profit is calculated by taking revenue minus COGs. It represents the profits that are made from selling leather wallets. However, we have not deducted the expenses of office rental, paying bills, paying employee salaries and etc. All these are known as “Operating expenses”.
“Operating expenses” are expenses that are NOT related to making the leather wallets. For example, paying rent for the office building has nothing to do with producing wallets. The receptionist and accountants in the office have nothing to do with producing wallets. Running marketing campaigns have nothing to do with producing wallets.
These are costs that do not contribute to the production of wallets. Operating expenses is separated from the cost of goods sold and they come under gross profits.
Hence, it is important to take note here that we have talked about two types of expenses.
The first is COGs or the expenses incurred to make our leather wallets. The second is operating expenses which are expenses that are NOT related to making the wallets.
If we take gross profit minus operating expenses, it will give us the operating income of a company. Operating income is sometimes referred to as earnings before interests and taxes or EBIT.
While gross profit represents the profits earned from selling wallets, operating income represents the profits earned from running a business of selling wallets. This is because we have to factor in costs from renting, hiring, marketing, research, and utility bills.
There are still some expenses that we have not considered. Interests expenses and taxes. Since these are non-operating in nature, the line items fall below operating income.
Assuming that company XYZ borrowed a loan to start this business, then we have to pay interest expenses to the creditors.
Earnings before taxes (EBT) is then computed by taking operating income minus interest expenses.
Finally, we have to pay corporate taxes to the government.
Earnings before taxes minus taxes would give us the bottom-line which is the net income.
This is the money that is left for the business owners after paying for COGs, operating expenses, creditors and tax authorities.
The final net income figure flows into the “Retained Earnings” under the balance sheet. This will be discussed in the next series.
When a new year starts, the company would re-record all the line items in the income statement again.
2. How to Read an Income Statement?
Now that we know the structure and definition of an income statement, the next question is how to analyze it?
Horizontal Analysis for Income Statement
The first thing I always do is to pull out the past 5-years or 10-years of a company’s income statement.
You can’t tell whether the financial figures are strong or weak by looking at a single year. It has to be compared across previous years to be meaningful.
This is known as horizontal analysis of financial statements.
To illustrate, let’s look at company XYZ’s past five years’ income statement.
You can immediately gather more insights rather than looking at a single year of financial figures.
Income Statement Trend Analysis
For example, the $50,000 revenue in 2019 doesn’t tell us anything. But if we compared it over the past five years, we can see that it has grown 4% from the prior year and the revenue trend is increasing.
Here are some of the basic things you want to look at when reading an income statement of a company.
Firstly, revenue is growing steadily. This is very important as you want to invest in a company that is making more money every year.
Secondly, you can compare the year-on-year revenue growth rate. This tells us the momentum of the company’s growth and earnings. If the growth rate is slowing, it means earnings would probably also slow down.
It also tells us which stage or cycle the company is at. Is it a small-cap young company at the growth phase? Or is it a big and stable company at the maturing phase?
Gross Profit Margin %
Thirdly, you can compare the gross profit margin over the years. Gross Profit Margin is calculated by taking Gross Profits divided by Revenue.
Gross profit margin % tells us how profitable it is selling leather wallets. We are just talking about buying materials to make the wallets and selling them at the market price.
This is excluding all the other operating expenses as discussed earlier.
If a company’s gross profit margin % is declining, it means either two things. One, people are not interested in your wallets anymore and sales are falling. Two, the production costs for making the wallets are increasing and you can’t control it.
More research and investigation should be done to determine if it is still a good idea to hold on to the company. Is it a temporary problem? Are there new competitors? Is there a structural or technological shift in trend? *Think about Singtel, Singpost and Singapore Press Holdings (SPH).
If you invest in a company and own shares in it, you are technically a business owner. Therefore, it should concern you that earnings are falling as a part of the company’s profits and dividends are yours.
So far we have only covered revenue, COGs and gross profits. Let’s move down the line items.
3. The Reading Flow of an Income Statement
Generally, an income statement is read from the top-most line item all the way down to the bottom. That’s why net profits are often called the bottom-line figure.
Similarly, when analyzing an income statement, you should first look at the gross profit margin before moving on to operating income margin and finally net profit margin.
Think of it as a tiered-water fountain. Revenue is all the way at the top and net profits are all the way at the bottom. The water you are allowed to collect is the bottom-most bucket.
Those in-between represents payment to suppliers, creditors, employees, property manager, tax authorities and etc.
Using the same analogy, if you realized that you are collecting lesser water (lower profits), you would start by looking at the top.
Is it less water are coming in? Are there too many leakages in between? Where is the water going? Water is money in this case.
Operating Income/EBIT Margin %
While gross profit tells us how profitable a company is in selling its products. We also have to ask how efficient is the management controlling operating costs.
A commonly used metric is the EBIT margin or operating income margin. It is calculated by taking operating income divided by revenue.
Difference between Gross Profit margin and EBIT margin
Gross profit margin measures how profitable it is to make and sell wallets. It also tells us how efficient the management is able to control production costs.
On the other hand, the EBIT margin measures how profitable it is to run a business that sells wallets. It also tells us how efficient the management is able to control operating costs.
Once again, you want to see consistent and increasing revenue, gross profit margin and EBIT margin.
The gross profit margin can be increasing over the years. You might think that is good news, the company is making more money.
But what if they are spending twice or 3x the amount on marketing expenses?
Then the operating expenses would have eaten off all the sales made and your EBIT margin would be declining.
Hence, it is important that EBIT margin is also increasing as that means the company is able to keep operating costs in control as the business expands.
Marketing Expenses-to-Sales Ratio
One way to check for the above question is simply to find out the proportion of marketing expenses as a % of revenue. It can be calculated by taking marketing expenses divided by revenue.
You can see that throughout the years, company XYZ is able to maintain its marketing expenses at about 18%. So we know that they are not aggressively spending on marketing to increase sales.
Do note that you can check any line item you are interested in.
For example, you want to see how innovative the company is, then you can calculate R&D as a % of revenue. You want to check if the company is giving out too many bonuses, then you can take calculate employee salary as a % of revenue.
It gives you a hint on how there are no hard rules in financial analysis. Understanding the concept and logical reasoning behind the formulas is more important.
Net Income Margin
Lastly, if we pay off interests and taxes using our operating income, it would give us the bottom-line figure which is the net income.
Remember the tiered-fountain analogy, the net income is whatever that is left for the business owners after paying everybody.
Net Profit margin It is calculated by taking net income divided by revenue.
Once again, you want to see net income margins improving over the years.
A business can have a high gross profit margin, high EBIT margin but yet not so high net profits margin.
This happens when all the profits are highly driven by debt. When a company borrows a lot, its interest expenses would be significantly higher also.
This is risky, but how do we tell from an income statement whether the company’s financial position is risky or healthy?
Interest Coverage Ratio
This can be done by calculating the interest coverage ratio. It is a very powerful tool to evaluate the liquidity of a company. You will see this commonly discussed everywhere, including my previous posts.
Interest Coverage Ratio is calculated by taking operating income or EBIT divided by interest expenses.
Essentially, what you are trying to ask is how many times can my operating income pay down the interest expense?
The higher the number the better, as that means the interest amount is insignificant relative to EBIT.
What you don’t want to see is those company that has a very low interest coverage ratio. If your interest coverage is low, it means you borrowed a lot and your interest expenses are very high. BUT your earnings are very little and you are struggling to pay the interests.
Imagine my EBIT is $1,500 and the interest expense is $1,000, the coverage ratio would be 1.5 which is very low.
It means that my operating income for the current year can only pay for the interest expenses 1.5 times. If no income came in during the 2nd year, I would have to force-sell my assets or declare bankruptcy to repay the creditors.
Hence, the higher the ratio the better as it gives you a greater buffer. Personally, I would prefer to see an interest coverage of at least 5 and above.
This is how the interest coverage ratio gives you a clue about how risky the company is.
Earnings Per Share (EPS)
Using the net income figure, we can calculate a variety of other ratios and metrics that tell us different stories.
I would only cover the main ratios that are commonly used in an income statement.
Firstly, we can calculate the earnings per share. It simply means how much net profits are you getting for every unit of share you own.
If you own a share of the company, then a portion of the company’s net profits belong to you. Earnings per share is calculated by taking net profits divided by total outstanding shares.
As with all other metrics, you want to see increasing EPS. An increasing EPS generally means increasing net profits.
However, the downside is EPS can be manipulated. For example, net profits might remain the same but the EPS is increasing. How is that possible?
The company can buy back its own shares, thus reducing the total number of outstanding shares. Assuming net profits remain constant, if the denominator decreases, the results would increase.
These are some of the possible tricks that a company can do. Hence, do monitor the net profits also if you are looking at EPS.
Warren Buffet sees increasing EPS as one of his criteria in analyzing companies. An increasing EPS simply means the company is making more net profits for the shareholders every year. With the EPS figure, you can also calculate the P/E ratio.
Price-to-Earnings Ratio (P/E Ratio)
The P/E ratio measures much are you paying for every dollar of net profit the company made.
It is calculated by taking the price per share divided by earnings per share.
If the earnings per share is $3 and the share price is $45, then the P/E ratio would be 15 (45 divided by 3). This means I am willing to pay $15 to buy a company that makes a net profit of $1.
Then you might ask why would anyone pay $15 for $1 of earnings? Well, people buy it because they think the company is solid, there is huge growth potential and they are expecting higher earnings growth.
How to tell if a Stock is Overvalued or Undervalued?
The P/E ratio gives us a clue as to how expensive or cheap a stock price is.
Imagine in the above scenario that the share price rose to $240, then the P/E ratio would increase from 15 to 80 (240 divided by 3). Does it make sense to pay $80 for a share price that earns $1 in net profit?
The answer is it depends. Amazon’s P/E ratio is 78, but people are still buying because they see huge potential.
Therefore, you must compare against the past years and get a 5-year P/E average or a 10-year P/E average as a benchmark for comparison.
If the average is 80, then it is not overvalued. But if the average is 30, then it is highly overvalued.
It is also equally important to compare the P/E ratio with the industry benchmark. Different industries have different P/E ratios. A P/E ratio of 80 might look high, but yet it can be normal within the industry.
Hence, it is better to look at the P/E relative to something rather than looking at it as an absolute value.
Return on Equity (ROE)
Lastly, you can calculate return on equity or ROE. The formula for ROE is net profits divided by shareholders’ equity.
This measures how efficient the company is generating net profits for every dollar of equity invested.
What does it mean by “every dollar of equity”?
How does a Company Raise Capital?
Very simply, a company raises capital in two ways: debt or equity. Debt is simply borrowing a loan from the bank and repaying them with interest expenses + principal.
On the other hand, equity is the business owner’s own money that he invested. The business can also issue shares to the public to raise money. This process is known as an IPO.
Hence, equity means the money raised by the owners and investors PLUS all the accumulated retained earnings over the years.
Remember the net income in every year-end flows from the income statement to retained earnings in the balance sheet? All these net income belongs to the owners and shareholders.
Another simpler method to find out shareholders’ equity is simply to take total assets minus total liabilities.
Why is ROE important? It is trying to ask if I invest $1 in your company, how much net profits can you make? If the ROE is 15%, it means the company makes $0.15 in net profits for every dollar invested.
Hence, ROE tells us how efficient the company is using shareholders’ money to generate net profits. The higher the ROE, the better.
Again, as you start to get the hang of it, it is of no use to look at the ROE for a single year. You can look at the trend or compare either against the previous years or industry average.
In summary, these are the basic building blocks that make up a simple income statement.
Firstly, we covered the structure and definitions of each line items in the income statement.
Secondly, we look at how to read and analyze an income statement.
While the list is not exhaustive, here are some of the common metrics you would often see.
- Gross Profit Margin
- EBIT Margin
- Net Income Margin
- Interest Coverage Ratio
- Earnings Per Share (EPS)
- Price-to-Earnings (P/E Ratio)
- Return on Equity (ROE)
Thirdly, remember that there are no hard rules or formulas when you read an income statement. The logical reasoning behind is more important.
Lastly, looking at a single year figure is not meaningful. Regardless of whether it is the income statement figures or the financial ratios, it has to be compared against something.
We can either compare it against previous years or compare it against the industry average.
Hopefully, you have gained a better understanding of how to read an income statement. Start by practising reading a few examples of income statements that are found in a company’s annual report.
The more you read, the better you become. Then you would realise it really isn’t that difficult after all.