Part 1: Interpreting Financial Statements – Income Statement

“It’s the language of business and it’s an imperfect language”

-Warren Buffett-

Welcome to part 1 where we will be interpreting income statements. Every investment requires some basic level of accounting scrutiny.

What are financial statements? They provide an overview of a business’s current and prior period results, as well as supplementary notes relating to the current and future business conditions.

Income Statements basically tells you where the money is going, where its coming from and how much the business has to operate with.

Which makes sense as to why thorough understanding of financial statements is essential in evaluating a company’s financial performance and condition. Financial statements are broken into 3 key sections: Income Statement, Balance Sheet and Cash Flow Statement.

In part one of this series we will be going through how to dissect an income statement using an example from a real company below:

Introduction into Interpreting Income Statements

An income statement has three main components which are its revenue, expenses and profit/loss for a financial period. While it is important to know if a company is profitable, its not the only measurement that you should be basing your investment on. There are several margins that you are able to calculate to determine if the company has a long-term competitive advantage and if it can continue to produce greater returns.

Interpreting Income Statements – Revenue

The revenue is the total gross amount of sales a company has collected during the record period. The fact that a company generates an extreme amount of sales does not translate to profitability. The revenue itself does not tell you much until you deduct all expenses to get the underlying net profit.

Interpreting Income Statements – Cost Of Goods

Cost of goods refers to the amount that is used in purchasing, manufacturing and the labour involved in producing its product to be sold. From the income statement above we can see that the total COG is $209,608,000. From this we can calculate the gross profit by: Revenue subtract COG = $438,575,000 – $209,608,000 = $248,967,000

Interpreting Income Statements – Operating Expense

These are the company’s costs relating to research and development, selling and administrative cost (SGA), interest expense, depreciation and amortization, impairment charges and other (non-recurring expenses, non operating expenses etc).

When all these expenses are added it equals to the operating expense of the company. Subtracting these costs from the company’s gross profit will give you the operating profit of the company, also referred to as earnings before interest and tax (EBIT).

SGA – Selling, General and Administration

The cost for direct and indirect selling expenses including payroll for management and employees , advertising, travel costs, legal fees and the likes.

R&D – Research and Development

Companies like technology or pharmaceuticals are always researching new products or patents to have an advantage over their competition.

Because there is always threat of newer technology or drugs being developed, companies in this field have to spend large amounts of their resources on developing new products.

Pharmaceuticals on average spend roughly on average15% of their revenue on R&D, with some as high as 29%.

High R&D costs eats into gross profit and there are many times where these research do not translate to any successful products. Watch out for company’s with consistently high R&D expenses.

Depreciation and Amortisation

Depreciation relates to tangible objects (equipment/buildings), where as amortization relates to intangible objects (patents, intellectual property). All machinery and buildings will eventually wear out over time, and patents will lose its effect after its allocated period.

Depreciation and amortisation allows for these assets to be expensed over a period of time. This accounting method allows for a more accurate depiction of a companies expense.

Depreciation is a real cost of doing business because in the future these things will need to be replaced.

Interest and Expense

Also known as finance cost, is the interest that is paid on the debt carried on a company’s balance sheet. While little debt is good, large amounts of debt is unfavourable for a company’s bottom line.

There are some instances where companies are paying more interest than they earn.

Airlines are serial offenders of excess debt. They often pay a large percentage of their operating income to interest expenses. Generally a payout of 15% or less is a good ratio to be paying out of operating income. A lower payout ratio suggests that the company is able to fulfill its obligations.

Interpreting Income Statements – EBIT

Earnings before interest and tax is the company income after all expenses are deducted but before interest is subtracted. Pre-tax earnings is usually what is used to calculate the value of a business on the open market. All investment returns are marketed on a pre-tax basis. Since most businesses compete with each other its convenient to compare them on equal terms.

Income Tax expense

Just like all taxpayers, companies too need to pay their dues. What is interesting about income tax is that it reflects the company’s true pre-tax earnings. How much a company pays in income tax tells you if what they recorded on their income statement is honest.

Australia has a 30% company tax rate and for small businesses it is 27.5%. In some limited circumstances such as industry or business structure, tax rates may vary. To see if a company is recording their true earnings, deduct 30% from their pre-tax earnings. Then compare it to their stated income tax value.

If the remainder doesn’t balance, you had better start asking some questions. From the above income statement we can check by taking the company EBIT of $42,882 and multiplying it by 30% = 42,882 x 0.30 =$12,864.60. This value is fairly close to its reported $12,699.

Interpreting Income Statements – Net Profit

This is the amount that is calculated after deducting every expenses such as operating expense, finance cost and taxes. A single years net profit is worthless and needs to be compared to previous years.

Net profit should show an consistent upward trend from previous corresponding financial years. This should suggest that the company has both durability and competitive edge.

A company that has a 15% – 20% or more net margin ratio is considered fairly durable.

Earnings Per Share (EPS)

Earnings per share is the net profit of a company on a per share basis for the recorded accounting period. The EPS will reflect the value of the company’s stock price. The more a company earns per share the higher their share price should be.

To calculate the EPS you simply divide net profit by total shares outstanding. In most instances, the annual report will state the EPS at the bottom of the income statement.

A single year EPS will not tell you much. Comparing this value to a period of 10 years or more can give you insight on the trajectory of a company’s financial performance and competitive durability.

Generally a company that has a consistently growing upward earnings trend is a good sign. Whereas sporadic earnings or downward trends are signs of concern.

Margins To Calculate

All values are in the Millions$

Gross Margin

Represents the the percentage a company retains after incurring direct costs of selling its products. The higher the margin indicates a competitive advantage as they have larger funds to satisfy financial obligations. This is calculated by gross profit ÷ revenue.
From the example statement above we can calculate as follows: $248,967 ÷ $438,574 = 56.7%

SGA Margin

Represents the amount of gross profit dedicated to direct and indirect costs of operation. Like any expenses the lower the percentage the more favourable it will be. It is calculate by SGA ÷ gross profit.
From the example statement above we can calculate as follows:
-Total SGA cost = $82,021,000 + $40,428 + $13,954 + $3,839 + $16,639 = $156,881
-Gross Profit = $248,967
Therefore SGA Margin = $156,881 ÷ $248,967 = 63%

From a business perspective SGA costs under 30% is considered fantastic, but this does depend on the industry. Higher costs usually relate to highly competitive industry or business economics. In a one year period SGA cost will not tell you much, and should be compared with prior periods.

If the costs are consistent (KEY WORD – CONSISTENT), I would not worry too much. But if the costs are rising each year it should pose a concern.

Interest Coverage Ratio

This refers to the ratio of your earnings before depreciation and amortization (EBITDA) that is used to pay interest bearing liabilities.

An income coverage ratio of 1.5 and above is considered good, the higher the value the better it is. It provides an insight on how easily a company can pay its debt obligations.

The interest coverage ratio is calculated by EBITDA ÷ interest expense
From the above statement we can calculate as follows: $57,181 ÷ $12,699 = 4.5x . This indicates that the company has a high chance of covering its debts.

Net Profit Margin

Measures the amount of profit that is generated from a percentage of its revenue. Generally a higher margin is better than lower margin.

Consider two separate companies in the same industry. One has a net profit margin of 3% and the other 7%.

In a hypothetical scenario, a 4% increase in expenses due to economic downturn will result in one company resulting in a -1% loss and the other still making a 3% net profit.

Net profit margin is calculated by net profit ÷ revenue. From the above statement we can calculate as follows: $23,591 ÷ $438,574 = 5.4%

Takeaway

The income statement is one of the three financial statements that needs to be read in order to evaluate a company’s performance. It should not be read as a standalone document, and needs to be compared with prior years results. Stay tuned for part 2 of this series, where we will learn how to dissect the balance sheet.

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