Management Information |
Five Tips for Analyzing an Income Statement
In today's article, we'll be looking at the income statement, which is the most deceptively simple of the major financial statements. I say simple because it's just a list of all the revenue, minus all the expenses, to calculate what's left over in profit. It's no more difficult than putting your family budget together, right? That's where the deceptive part of the description comes in. The items on the income statement are easily manipulated by, say, less-than-honest management, and don't necessarily represent the true situation at a company. Even totally honest companies can have income statements that don't represent economic reality. Cash flows define economic reality, revenue and expenses define accounting reality. You see, the difference between your household budget and a company's income statement is their relationships to actual cash flows. Your household budget will generally match your cash inflows and outflows. Not so with an income statement. Income statements can vary significantly from the company's cash flow, meaning that a company in economic trouble can show a very "good" income statement up until the day it goes bankrupt. Generally speaking, though, the income statement is a good place to start when evaluating a company. In my forthcoming e-book, Fundamentals of Financial Statement Analysis, I lay out the process for evaluating the health of a company through the financial statements. I'm shooting for publication in the beginning of 2004, but in the meantime, here are some tips and strategies for evaluating an income statement. 1. Create a Common Size Statement What's a common size statement, you ask? It's the income statement, only with each line item represented as a percentage of sales. This is easy to do with a spreadsheet on your computer, but you can do it on paper just as well. Net Sales is always 100% at the top, and each of the expenses is divided by total sales to arrive at a percentage. For example, if a company has $100 in sales and $50 in cost of goods sold, the common size statement will look like this: Sales 100% Cost of Goods Sold 50% Gross Profit 50% The importance of the common size statement can't be overstated. It gives you the calculation of all your profit margins, from gross to net, and shows how much each cost item takes away from your profits. 2. Create a Year-to-Year Comparison Statement The next step is to make a year-to-year comparison statement. You can't evaluate financial statements for just a single year; they have to be compared to previous years. The only formula you need to know for these calculations is: (current year / previous year) - 1 = % change Again, a spreadsheet makes this process so much easier, but it can be done by hand. I like to have five years of data, which yields four years of comparison data. This way you aren't just looking at an exceptionally good or bad year for the analysis. Plus, you can get a reasonable estimate of future growth when you do your discounted cash flow analysis. (I'll have more on the Discounted Cash Flow in the future.) 3. Read the Management Discussion and Analysis If you take the time to read the MD&A, you'll have an advantage on most investors. A majority of individual investors simply skip this part, and go right to calculating ratios or looking at the EPS. Seasoned investors know that the MD&A provides the backup data for the income statement line items, and they will take time to read it. A good Management Discussion and Analysis will give you the details you need to understand the items on the income statement. You should get segmented sales data, cost drivers, etc. in this section. If you can't make sense of the MD&A, that should set off alarm bells in your head. If you don't find the information you need in the MD&A, you should? 4. Look at the Notes to Consolidated Financial Statements (Footnotes) The footnotes tend to be more difficult to understand than the MD&A, but you get really detailed information here. The footnotes are where management hides the dirty laundry. And when you've got guys making today's corporate salaries that laundry pile can get pretty big. Here's where you'll likely find what you couldn't in the MD&A, it's just that in the notes you may have to do some putting of two and two together. Take your time sifting through this section, and try to identify the income statement items that relate to the footnotes you're reading. You can do it the other way around, as well, and look for the footnotes that relate to the income statement item. If you still can't figure out what the company is doing, after going through the MD&A and the footnotes, you may want to consider looking at another company. This one may be too complicated (or too devious) for your abilities. Don't feel bad about not understanding the business, either. Even the great Warren Buffett admits that he doesn't understand some businesses, and he never lets his ego run away from him. If he can't understand it, he won't invest in it. I recommend you do the same thing. 5. Look at segmented data I always like to look at segmented sales and profit figures to determine which product lines, or operating businesses, are growing sales faster than the others. This information is usually in the MD&A. If you can, try to find the operating profit for each business segment as well. Then look at the profit margins for each segment of the business. You may be surprised at the different profitability levels of each business segment. Compare the segment with the fastest growing sales versus the segment with the highest operating profit. If these are the same segment, that's good news. If they aren't, that's okay too. You do want to watch out for companies that have the lowest operating profit in their fastest growing segment. This could cause a decline in the company's overall profitability as sales grow faster than profits. For example, a segment that's growing 5% a year, but has a 10% margin, will contribute more to total operating profit growth than a segment growing at 20% a year with a 1% margin. I hope you find these tips helpful. Of course, there are plenty of other analysis tools that you can use to evaluate financial statements. It's important that you keep looking for more and better ways to analyze company data, because constant learning will make you a consistently better investor. About The Author Chris Mallon is the editor and publisher of the Undervalued Weekly, a free personal finance and investment newsletter dedicated to creating smarter investors. To sign up for the Undervalued Weekly, send e-mail to underval@hot-response.com, or sign-up through the website at www.dynamicinvestors.net/index7.html; chrismallon@dynamicinvestors.net
MORE RESOURCES: Unable to open RSS Feed $XMLfilename with error HTTP ERROR: 404, exiting |
RELATED ARTICLES
Problem-Solving Success Tip: Use Your Project Management Skills Solving a big problem is a project: you're far more likely to solve it successfully if you treat it like one. That means you'll need to identify tasks, make and adjust assignments, and keep track of what is due when. 5 Steps to Continuous Process Improvement Part One of Creating Well-Defined Processes SeriesWhat if your sales increased from $100,000 to $110,000 per day and your profit increased from $10,000 to $11,000 - did you improve by 10%? The answer might shock you.. The Comfort Zone The Comfort Zone I have a friend named Gene, a serial entrepreneur who currently runs a software business. Like many people, last year was a tough one for his company. Procrastination and JDI! In a management role procrastination can seriously hold back progress and demotivate individuals and teams who, full of innovation and drive to move forward, get frustrated and confused when action is held up.There are a number of steps that will help the procrastinating manager. 6 Steps To Effective Management During Change Take the pain out of gain and decrease the upheaval surrounding change by following six commonsense steps to effective management.Step 1: Establish ObjectivesThe process must begin with a clear and detailed statement of objectives and move from there to goal design. Increase Productivity: Five Powerful Actions How can you make the best use of your energy to increase productivity each day? Here are five actions that can increase productivity and leave energy to spare. They will also help you to achieve more balance between your work and personal life. Data Delivers Credibility Over the past couple of days I've been setting up visitor counters, so people in another organization can accurately count the number of people who visit their event.They got the idea (and the counters) from an association I belong to, and they, too, are learning how data delivers credibility. Time-Wasting Problems - One Question to Move You Forward In any organisation, progress is frequently impaired by the time taken up to resolve problems that occur again and again - usually with people's performance (or not!). At a macro level, there could just seem to be 'lots of problems', which is a symptom in itself. Five Habits of Highly Effective Conflict Resolvers Steven Covey had the right idea. There are discreet skills and attitudes, habits if you will, that can elevate your conflict practice to a new level. Are you NICE or do you CARE? Are you NICE or do you CARE?Most people and most managers want to be nice. After all, it's easier to be nice than to not be nice. Tales from the Corporate Frontlines: The Organizational Structure of Our Growing Business This article relates to the organizational structure competency, commonly evaluated in employee satisfaction surveys. It shows how structural concerns can affect the typical employee workday, as well as feelings towards your organization's management hierarchy and reporting structure. Collaboration: 3 Keys to Keeping Your Documents from Getting Lost in the Shuffle Often, collaborating documents in a team or in a business can feel like a complex sports play gone wrong. The ball gets passed off to the wrong person, dropped, or even lost. Succession Planning? ... Not on My Watch! At first blush, it would appear there is no shortage of Succession Planning Advocates convinced in theory, the importance and benefits of corporate Succession Planning. In practice, however, real succession planning - or the overt lack thereof - runs juxtaposed to principle. The Communications Myth Living in the 21st Century is truly marvelous, isn't it? We live in a world of instant communications where everything we need to know is right at our fingertips. The moment anything of significance occurs it is instantly transferred around the globe making us the most well informed generation in the history of the world. Must Project Managers Be Technically Savvy? "Must Project Managers be technically savvy?" This topic always seems to cause quite a stir. While some believe that all you need to manage a project is a PMP certification, others are convinced that you can't successfully manage a software development project unless you truly understand the intricacies of the product. Performance Appraisals: Nightmares or Sweet Dreams Some managers think of performance appraisal meetings and recollections of torn Achilles' heels or root canals immediately surface. They're sort of "been there, don't want to go again" situations. Intercultural Management The role of a manager is evolving in response to the needs of companies operating on the international stage. The complexities of globalisation brought to the area of management are great and require the 21st century manager to adapt in order to offer modern solutions to modern problems. Innovation Management - idea selection, development and commercialisation, what are the differences? Creativity can be defined as problem identification and idea generation whilst innovation can be defined as idea selection, development and commercialisation.There are distinct processes that enhance problem identification and idea generation and, similarly, distinct processes that enhance idea selection, development and commercialisation. Change Management: Getting Everyone on Board the Change Train How do you get everyone on board the change train that is gaining speed and heading out of the station? How do you get your people to, not only go through the motions, but also actually "buy into" the changes that are necessary? People's resistance to change is not entirely irrational; it stems from good and understandable concerns. Here are the six most common reasons people resist change and tactics to convert this resistance to commitment. When Business Becomes A Battlefield "We have to be careful it's like a minefield out there""I like to lob the odd grenade into the meeting to shake things up""You have to watch your back all the time with her""We need to attack whilst they are in a weak position""There was blood all over the carpet after he had finished with them"What is your reaction when you are in situations where you hear these kind of messages? What sort of tone and atmosphere do you think they create?These words and phrases are becoming more common-place language amongst managers and are indicators of how things are done in their business. They are also indicative of the growing number of leaders who believe that running a business is like waging war or engaging in a military operation. |
home | site map | contact us |