The income statement provides you with a wealth of important information about the company; its growth; and its financial strength. The range of analysis performed from information on income statement includes not only the current outcomes and comparisons, but also comparisons between the current results and past results. The trends are all-important; and you recognize those trends by observing how they evolve over time.
To find long-term trend information, whether for stocks you own or for those you are thinking of buying, check the “Investor Relations” link on the corporate website. Most companies include links to several years’ annual reports, which also contain
H o w t o S p o t t h e K e y Tr e n d s 157
gross margin the percentage of gross profit to revenues on the income statement.
return on equity
a ratio comparing profits before interest and taxes (operating profit) to a corporation’s net worth.
net return the return on sales, usually expressed as a percentage. Earn- ings are divided by revenues to determine the net return.
current yield the percentage return investors earn from divi- dends paid by a corporation. To calculate, divide the full year’s dividend payment by the current stock price. As the stock price falls, current yield rises;
and as the stock price rises, current yield declines.
Looking at a single income statement reveals some information; but the whole picture emerges only when you look at the numbers over a longer period of time, from one income statement to another.
Key Point
both income statements and selected financial in- formation. Many of the key long-term ratios you will need can be found in these statements or on separate financial highlights that the corporate website provides.
A key trend, of course, is the growth in rev- enues and related earnings. One potential problem is in finding these forms of information by seg- ment. Many corporations have dissimilar lines of business, each with its own separate market and profitability attributes. In these instances, it is a common practice to include a detailed breakdown on yearly revenues and earnings by operating unit (also called segment, affiliate, or subsidiary).
The following four major trends are the most important on the in- come statement:
1. Growth in revenues. Among all of the fundamental indicators, revenues command more interest than any others, even earnings.
A widespread belief states that as long as revenues continue to
bottom line the last value on the income state- ment, represent- ing the earnings after all operating costs and ex- penses, interest, and taxes have been deducted from revenues.
Percentages or Margins of Return Dollar Value
Gross margin
Operating margin
Net return Pretax margin Revenues
Minus: Cost of goods sold
= Gross profit
Minus: Operating expenses
Less: Income tax liability
= Operating profit
= Net profit
= Pretax profit
Plus or Minus: Other Income or Expense
FIGURE 8.1 Income Statement Labels
expand, the company is healthy, even if earnings do not follow. This belief is wrong, because revenue expansion is only worthwhile if profits remain strong as well.
There is a tendency during periods of rev- enue expansion to allow profits to dimin- ish, and even to experience net losses.
Revenue expansion is not a good cause if, as part of the price of that expansion, earnings are eroded. This is why reviewing revenues is only a part of the overall task of analyzing the income statement. You need more.
2. Gross profit margin. Revenue expansion may also mean reduction in gross profit.
The gross profit margin is a good indicator to track whether the revenue/cost relation- ship is remaining the same while revenues expand. It should, as long as the mix of business is constant as well. If and when a corporation acquires a new affiliate, or sells
off an old one, the change might affect the gross profit margin;
so when you see a change in the margin (gross profit divided by revenues, expressed as a percentage) before you conclude that something has gone wrong, check the acquisition and sale activ- ity for the year; that might explain the change.
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operating profit the profit after costs and ex- penses are de- ducted from revenues but not counting “other”
income and ex- penses such as interest, capital gains and losses, or currency ex- change, and also not counting liability for in- come taxes.
pretax profit the net profit after all costs and expenses are deducted from revenues, before deducting liability for federal, state, or local income taxes.
Higher revenue is a positive trend—unless earn- ings are flat or falling at the same time. If that is happening, what good are those higher rev- enues?
Key Point
Costs should track related revenues; but be careful to allow adjust- ments when the mix of business changes from one year to the next.
That might also affect gross margin.
Key Point
3. Expenses in relation to revenues. Another area likely to grow dur- ing periods of revenue is expansion is expenses. This group in- cludes selling expenses as well as general and administrative expenses (overhead). Generally speaking, management is sup- posed to be able to keep expense expansion to a minimum even when revenues are growing. As a company expands into new ter- ritory, opens new offices, hires more employees, and pays to ad- vertise its products, higher expenses are unavoidable. A valuable indicator is to compare expenses to revenues and track the per- centage. It is reasonable to expect that expenses represent either a fixed percentage of revenues or, if they change at all, it should be to become a smaller percentage. When expenses outpace rev- enues, it is a sign of poor management—unless the trend is ex- plained and that explanation makes sense. (Higher expenses in a single year could be explained as a nonrecurring but necessary change due to expansion.) The worst of all situations—but one that is not uncommon—is to experience rising revenues, rising costs (thus, shrinking gross profits), and rising expenses. If a company’s profits are falling or if it is reporting net losses, why should expenses be on the rise? There is no reasonable explana- tion, and it would be a highly negative condition.
4. Operating profit margin. When costs and expenses are deducted from revenues, you end up with the operating profit or net profit. This dollar value, divided by revenues, gives you the oper- ating profit margin. Why focus on this rather than on the after- tax net profit? The operating profit margin identifies the recurring, core earnings of the company. While the EPS is most likely based on the bottom line, you will often see two versions of EPS, one for the operating EPS and the other for the net EPS.
The distinction can be important. When corporations report large gains from the sale of a segment or from capital assets, or
When expenses outpace revenues, there is a big problem. All slick explanations aside, when expenses increase too quickly, it means management is not doing its job.
Key Point
when its profits are affected by interest payments on long-term debt, not to mention tax liabilities, the difference between oper- ating profit and net profit can be significant.