"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"
How I Read An Income Statement
When looking at a company's financial statements, the income statement is usually the first, and sometimes the only, thing that investors look at. It tells you whether or not the company in question earned a profit. A new income statement is released every three months by most publicly-traded companies and is labeled according to the time period being reported, just like the balance sheet and cash flow statement. It starts at the top with the company's revenue, and then goes through the cost of goods sold, such as raw materials, labor, and goods for resale. This will then give you the company's gross margin. This is followed by the company's operating expenses, such as research and development, depreciation, and selling, general, and administrative expenses. This gives you the operating profit of the business. That is then followed by interest expenses and capital gains, before showing the net income of the company. A sample income statement is provided below. I will go through each line, showing you the most important things that you need to know.
Income Statement of XYZ Company ($ in millions)
|Cost of Goods Sold||$42,391|
|Research and Development||$0|
|Selling, General, and Administrative Expenses||$26,421|
|Total Operating Expenses||$29,625|
|Income Before Taxes||$12,291|
|Income Taxes Paid||$3,319|
|Net Income From Continuing Operations||$8,972|
|Gain (Loss) From Discontinued Operations||$1,784|
The total revenue is simply how much money came through the door on the sale of the company's products and services. Note that a lot of companies use the accrual method of accounting, where some sales are booked as revenue without having actually received the money. This figure, by itself, doesn't tell us anything as to whether the company in question is profitable.
Cost Of Goods Sold
The cost of goods sold, or cost of revenue, is the cost of raw materials and labor that went into producing the items or services for sale. The cost of items that were purchased for resale are also factored into the cost of goods sold. When this number is subtracted from the total revenues, we are left with the gross profit of the business, which in turn, gives us the gross margin of the business.
Let's consider the income statement of XYZ above. Its total revenue amounted to $85.076 billion. Its cost of goods sold was $42.391 billion. To compute the gross profit of XYZ, we subtract the cost of goods sold from the total revenue. This gives us a gross profit of $42.685 billion. If we then divide this figure by the total revenues, and multiply the quotient by 100, we get the gross margin of XYZ Company.
Gross Margin = (Gross Profit / Revenue) X 100 = ($42.685 / $85.076) X 100 = 50.1%
XYZ Company is carrying a gross margin of 50.1%.
The gross margin can offer us a clue as to whether or not the company in question has a sustainable competitive advantage that sets itself apart from its competition. Companies that are involved in commoditized businesses, like airlines, where there are a bunch of competitors all providing the same service or product, are typically in a race to the bottom on pricing, which hurts their revenues and margins. Companies with durable competitive advantages, however, don't have to worry about this, because they are offering something that their customers are willing to pay for, and that their competitors are not offering. For this reason, companies with durable competitive advantages tend to have higher gross margins than other companies. When looking at the gross margin, you generally like to see companies with gross margins of 40% or more, as this will often indicate a strong competitive advantage. With a gross margin of over 50%, XYZ might have one of these competitive advantages. It also helps to look back at the income statements over the past several years in order to see how consistent the gross margin is.
Now, we will examine the operating costs of the business. These operating costs can make a company with high gross margins go off the rails if not properly managed. These costs include research and development, selling costs, and depreciation. I will examine each of these three items in detail.
Research and Development
If you think that the company that you're researching has a competitive advantage, then you should try to find out where that advantage is coming from. In many cases, it may come from patents or technological innovations. The problem with these two items is that patents will eventually go away, while technological innovations might be replaced by something better. This may require some companies to spend a lot of money on research and development, so that new patents can replace patents that are expiring, and so that they can also stay a step ahead of their competition when it comes to new technologies. High costs in research and development can really eat into a company's margins, making it less profitable. Companies that have to spend a lot of money in this area have a major flaw in their competitive advantages, because those advantages are never a sure thing. Companies that often have to spend a lot of money on research and development include pharmaceutical companies and software manufacturers. The less money that a company has to spend on research and development in order to maintain a competitive advantage, the better.
Selling, General, and Administrative Costs
Selling, general, and administrative costs include the costs of everything that goes into selling a product or service. These costs include management salaries, advertising expenses, travel costs, commissions, and other related expenses. Like research and development costs, these expenses can really eat into a company's bottom line. One of the most important things to look at in regard to these costs is the consistency of its percentage of gross profit over a number of years. Companies that have sustainable competitive advantages tend to have selling, general, and administrative costs account for a consistent percentage of their gross profits, while those that don't have competitive advantages exhibit wildly fluctuating percentages from one year to the next. This is due largely to the fact that companies without competitive advantages have fluctuating revenues as their products become in vogue, and then go out of style or are replaced by something that is better than what they offer. As their revenues decline, their selling, general, and administrative costs eat up more of their gross profits. Companies that have durable competitive advantages don't have products that go out of style, and have brand strength that doesn't require as much effort to sell. Customers will often seek their products out. For these reasons, companies with sustainable competitive advantages will usually have selling, general, and administrative costs that consume well below 100% of their gross profits. In the case of XYZ, its selling, general, and administrative expenses account for less than 62% of its gross profit.
Depreciation is a very real expense that is often ignored by investors. It takes into account the fact that equipment wears out over time and will need to be replaced. When equipment is purchased, its cost is expensed over a period of years in the form of depreciation, and the depreciation represents a charge to the company's earnings. Companies that have strong and enduring competitive advantages usually are not involved in capital-intensive industries, where they would have to constantly invest and upgrade their equipment in order to stay a step ahead of their competition. These companies typically report depreciation figures that account for less than 10% of their gross profits, while other companies have been known to report depreciation expenses that account for more than 100% of their gross profits. When researching a potential investment, you generally like to see depreciation eat up less than 20% of the company's gross profit. In the case of XYZ, depreciation consumes less than 8% of its gross profit.
When you add up the costs of research and development, depreciation, and selling, general, and administrative costs, and then subtract them from the gross profit, you are then left with the operating profits of the company, and from that, the operating margin can be calculated.
Interest expenses consist of interest that the company has to pay on its debts. The more debt that a company has, the more interest that it has to pay. In this regard, the less, the better. Companies that are in capital-intensive industries have to invest constantly in new equipment and upgrades in order to stay competitive. These companies typically have a lot of interest expense that has a negative effect on their earnings. The same can be said for any company that is in a highly competitive environment. Companies with sustainable competitive advantages can usually make most of their investments with their operating cash flows, without the need for taking on a lot of debt, and they usually don't have to invest as much in upgrades and other items in order to stay competitive. To evaluate how much of a problem interest expenses can be, I like to divide the amount of interest expenses by its operating income. When I see that a company pays out less than 25% of its operating income in interest, that tells me that that particular company might have an advantage that sets itself apart from its competitors. In comparison, financially-distressed companies may pay upwards of 100% or more of its operating income in interest. In the case of XYZ, they pay out less than 6% of their operating income in interest. This shows that XYZ is not a financially-distressed company.
Profit From Discontinued Operations
A lot of times, companies will sell off some of their non-core assets and operations in order to focus on their core competencies. The profit or loss from these sales are recorded on the lower part of the income statement. These profits and losses are usually ignored by investors, as those operations no longer belong to the company, and the divestments are just one-time transactions that have no bearing on the company going forward.
After all of the expenses and taxes have been deducted from the total revenue, we are left with the net income, or profit, of the company. This tells us once and for all whether the company turned a profit. We usually like to see an overall uptrend in net income over several years of earnings history. This is how you can sometimes identify companies that have a sustainable competitive advantage. While most investors focus on per-share earnings instead of overall earnings, you need to consider that a lot of companies will buy back stock during the reporting period, reducing the number of shares outstanding and dividing the earnings over fewer shares. With all else being equal, a buyback program will cause earnings per share to rise, even if net income remains the same or falls. For this reason, you need to pay attention to the overall net income as well as earnings per share, in order to get a good idea of how the company in question is doing. You should also exclude any earnings or losses that came from discontinued operations, as they are just one-time items, and those operations are no longer with the company.
Another thing that is important here is the net profit margin of the company. This will tell you just how profitable the company is, and can give you an idea as to whether the company has a durable competitive advantage. To calculate the net margin, divide the net income by the total revenues and multiply by 100. If the company in question is turning a net profit margin of 20% or more, then that may mean that the company has a competitive advantage. Companies with low single-digit net margins or less are usually involved in highly competitive industries, where no one has a durable competitive advantage. In these industries, there is usually a race to the bottom on prices, which translates into lower revenues and lower profit margins. XYZ Company currently has a net margin of just under 13%, which is in the middle as to whether a company has a strong competitive advantage.
Earnings Per Share
As mentioned above, earnings per share is a very important metric that investors look at. This is because earnings per share will ultimately determine the price of a stock. Earnings per share are calculated by dividing the net income by the number of shares outstanding. Generally speaking, the higher the earnings per share, the higher the stock price. As is the case with net income, you want to look at the company's earnings per share over a ten-year period or longer in order to see how well the earnings have held up over time. You want to see consistency and an upward trend. This will show that the company doesn't have to constantly change its products, services, or business model in order to make money. If the earnings history is erratic, featuring swings between high profits and losses, then that may indicate that the company has been involved in a lot of boom and bust cycles, which makes everything a lot less predictable and is not an attribute of companies with durable competitive advantages.
From reviewing this article, you should now be able to effectively review an income statement for almost any publicly-traded company. Good luck to you!
"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"