15. How Do I Read and Analyze an Income Statement?

The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the revenues, expenses and net income generated by an organization over a specific period of time. It is one of the most heavily scrutinized financial statements issued by every organization. And though the data contained within this document is relatively simple, there is a great deal of useful information that can be garnered from it to help assess a firm’s historical financial performance and develop an estimate of its prospects. Because of this, it is critical for users to have a sound understanding of the story every income statement is trying to tell.

15.1. What Does an Income Statement Look Like?

While almost no two income statements look the same, they all possess a common set of data: total revenue, total expenses, and net income. Though this represents the minimum amount of data that must be provided, additional details for each section are frequently included to give users more insight into the organization’s financial activities. Some of the most common line items and the order in which they appear are listed below.

Product-level revenue: This line item depicts the revenue associated with a specific product the firm sells. There may be multiple lines if the organization sells several different products.

Cost of goods sold (COGS): This expense line item denotes the costs directly tied to the product. For example, a paper mill lists the cost of the pulp used to manufacture paper in the COGS section.

Gross profit: This is the amount of revenue left over after subtracting COGS. Simply put, this is the amount of revenue available to pay for operational expenses and compensate ownership.

Selling, general, and administrative expense (SG&A): This expense line item is an aggregation of all costs related to the sale of the firm’s product(s) and the general operation of the organization.

Interest Expense: This operating expense line item shows how much interest the firm paid to fund its operations during the period.

15.2. How Is It Used?

Income statements are meant to provide users with insights into the financial performance of an organization. Numerous metrics and analyses can be developed with this data to provide more in-depth assessments of the organization. However, when used in comparative company analysis, these metrics become valuable. In this type of analysis, income statement metrics such as total revenue growth and gross profit margin are calculated for similar companies within an industry and compared to one another. For example, see the metrics associated with a pair of technology manufacturers below.

TechOne

Revenue growth: 12.6% Gross profit margin: 74% Net profit margin: 35% Net income growth: 18.6%

Alpha Systems

Revenue growth: 16.2% Gross profit margin: 67% Net profit margin: 35% Net income growth: 19.6%

For an investor looking to purchases shares of a technology manufacturer, comparing the statistics of these two companies yields a number of insights that are not obvious if viewed on a standalone basis. The following are just a few of the conclusions that can be drawn.

On both revenue and net income growth basis, Alpha Systems is outperforming TechOne. As future growth prospects are highly important to every investor, Alpha Systems appears to be the more attractive option. TechOne has a lower COGS due to its higher gross profit margin than Alpha Systems. This suggests that TechOne can source its inputs for less than Alpha Systems, which could be indicative of an inherent competitive advantage. Despite both firms having the same net profit margin, Alpha Systems appears to have lower operating costs than TechOne based on the differences between gross and net profit margins. This implies Alpha Systems is operating its business more efficiently than TechOne.

Numerous other analyses can be performed as part of any comparative company analysis using the income statement. The point is that any income statement analysis should include some form of comparative analysis to give the reported numbers, and associated metrics, the needed context. By doing so, investors, management, and others can fully understand how an organization is performing financially and make informed decisions accordingly.

15.3. Fundamentals Explained

In business and economics, fundamentals represent the primary characteristics and business data necessary to determine the stability and health of an asset. This business data can include macroeconomic, large scale and microeconomic, smaller scale, factors to set a value on securities.

Key Takeaways

Fundamentals provide a method to set the financial value of a company, security or currency. Included in the fundamental analysis is basic qualitative and quantitative information that contributes to the asset’s financial or economic well-being. Macroeconomic fundamentals include topics that affect an economy at large. Microeconomic fundamentals focus on the activities within smaller segments of the economy.

15.4. Macroeconomics and Microeconomics

Macroeconomic fundamentals are topics that affect an economy at-large, including statistics regarding unemployment, supply and demand, growth, and inflation, as well as considerations for monetary or fiscal policy and international trade. These categories can be applied to the analysis of a large-scale economy as a whole or can be related to individual business activity to make changes based on macroeconomic influences.

Microeconomic fundamentals focus on the activities within smaller segments of the economy, such as a particular market or sector. This small-scale focus can include issues of supply and demand within the specified segment, labor, and both consumer and firm theories. Consumer theory investigates how people spend within their particular budget restraints. The theory of the firm states that a business exists and makes decisions to earn profits.

15.5. Fundamentals in Business

By looking at the economics of a business, including the overall management and the financial statements, investors are looking at a company’s fundamentals. Not only do these data points show the health of the business, but they also indicate the probability for further growth. A company with little debt and sufficient cash is considered to have strong fundamentals.

Strong fundamentals suggest that a business has a viable framework or financial structure. Conversely, those with weak fundamentals may have issues in the areas of debt obligation management, cost control or overall organizational management. A business with strong fundamentals may be more likely to survive adverse events, like economic recessions or depressions, than one with weaker fundamentals. Also, strength may indicate less risk should an investor consider purchasing securities associated with the businesses mentioned.

15.6. Economic Level Fundamental

While fundamentals are most often considered factors that relate to particular businesses or securities, national economies, and their currencies also have a set of fundamentals that can be analyzed. For example, interest rates, gross domestic product (GDP) growth, trade balance surplus/deficits, and inflation levels are some macroeconomic factors that are considered to be fundamentals of a currency’s value. Large scale, macroeconomic fundamentals are also part of the top-down analysis of individual companies.

15.7. Fundamental Analysis

Investors and financial analysts are interested in evaluating the fundamentals of a company to compare its economic position relative to its industry peers, to the broader market, or to itself over time. Fundamental analysis involves digging deep into a company’s financial statements to extract its profit and growth potential, relative riskiness, and to ultimately decide if its shares are over, under or fairly valued in the market.

Often fundamental analysis involves computing and analyzing ratios to make apples-to-apples comparisons. Some common fundamental analysis ratios include the

Debt-to-equity ratio (DE) measures how a company is financing its operations. The quick ratio measures the company’s ability to meet its short-term obligations. The degree of financial leverage (DFL) measures the stability or volatility of the earnings per share (EPS). The price-to-earnings (P/E) ratio compares investment to earnings dollars. DuPont analysis looks at return on equity (ROE) through looking at asset use efficiency, operating efficiency, and financial leverage.

Fundamental analysis should be carried out with a holistic approach, utilizing several ratios and including some bottom-up and well as top-down analysis to come to specific conclusions and actions.

15.8. Real World Example

In the fourth quarter of 2018, according to Market Watch, large-cap tech companies Microsoft and Apple had similar market caps for the first time since 2010. Although the two companies had similar market caps of about $850 billion, they had very different fundamentals. For example, Microsoft was trading at 45X earnings while Apple was trading at 15X earnings.

Also, while Microsoft’s earnings were predicated on software as a service (SaaS) and software sales, Apple’s were still primarily dependent on hardware sales. Apple’s revenue base is about 2½ times Microsoft’s, the global market for its devices is far more saturated than the global market for Microsoft’s software.

Though the two companies were comparable in size, Microsoft was positioned to take advantage of a rapidly growing market, while Apple was not.