The Basics of Income Statement Analysis

Learning how to analyze an income statement is an investing skill that pays. With it, you can enhance your knowledge of a company's annual report or Form 10-K filing, read reports and gather data to compete as a trader in the market, model a competitor's business structure, create ratios from scratch, or learn the facts you need to invest in a small business.

If the practice is new to you, there are a few basics to learn first, and a few factors to be aware of, that will build a solid base for your study.

Understanding the Income Statement

An income statement will show you a company's profit and loss over a given time. It was once more common to hear them called "profit and loss" (or "P&L"), but now both terms are used. Its core function is to express the net income by comparing gains and losses. You will often see this written as:

Net Income = (Total Revenue + Gains) – (Total Expenses + Losses)

A standard income statement will include many other figures that make up this core value:

• Revenue or sales
• Cost of goods sold (COGS)
• Gross profit
• Expenses
• Earnings before tax
• Taxes
• Net earnings

Some of these figures are simple, and some are more complex. Revenue or sales is the total amount of money taken. Cost of goods sold (COGS) is the amount of money that is paid upfront to buy supplies or pay for labor, or in other words, the direct cost of what is needed to make the product for sale. Gross profit refers to how much money is made after the cost of goods is paid for. Expenses are the amount of money it costs to run the full scope of operations.

Most of these figures depend on each other, and can be used to assess many features of a company. From revenue, for instance, you can subtract the cost of goods sold to find the gross profit. From gross profit, you can subtract expenses to arrive at earnings before tax (EBT). Subtract the amount of taxes from EBT to reveal net income or loss.

These numbers can be used in many ways to gain insight into a company's financial health.

Income Statement Analysis

Investors can use income statement analysis to calculate financial ratios that can be used to compare the same company year over year, or to compare one company to another.

For instance, you can compare one company's profits to those of its competitors by looking at a number of figures that express margins, such as gross profit margin, operating profit margin, and net profit margin. Or you could compare one company's earnings per share (EPS) to any other's to show you what a shareholder would receive per share in the event that assets were made liquid or if each company were to distribute its net income.

Vertical Analysis

When you compare each line up and down the statement to the top line (which is revenue), this is called "vertical analysis." Each line item becomes a percentage of a base figure. This method can be used to compare one line item to another very simply, such as to check how each may affect cash flow, or it can be used to show how the cost of one line item stands up against the cost of any other.

This can be helpful if, for instance, you are looking for a reason why a business might have taken certain actions, or where it may be spending in excess. Investors use this method for a dive deep into a company's current standing with regard to such metrics as working capital and total assets.

Horizontal Analysis

Horizontal analysis, on the other hand, compares the same figure across two or more time frames. This method is most often used for spotting trends. A single line item can be looked at over a long span of time, to view changes from year to year. For instance, you might wish to hone in on what factors may be driving a certain company's success (or failure) over the last few years. Some investors use this method to predict how well a business will perform in the months or years to come.

Limits of Income Statements

Because income statements have a few limits, they may not always be the best source to consult. It depends on what you're looking for. Capital structure and cash flow, just to name two, can make or break a firm, and you'll want to have correct figures.

It's Not the Whole Picture

Though income statements offer quite a bit of detail, they don't cover the full picture. The most notable absence is in the form that money takes, whether cash or credit. Income statements do not reflect whether sales were made in cash or by credit card, for instance. The same goes for payments. So, there's no true way to tell how much cash may be on hand at any given moment, or how much is due to come in.

Lack of Precise Figures

Since an income statement is meant to provide a full picture or overview, it will often rely on the use of estimates rather than precise figures. To explain, to get by day to day and make solid choices, companies might have to act fast. They need to be able to assess broad concepts in an efficient manner in order to function well, or they may need to predict future needs in order to make current choices.

In these cases, estimates can be very useful. For instance, they are often faced with coming up with a number to stand for the depreciation of their assets. After all, they can't know ahead of time how long a computer, copy machine, or corporate jet is going to last. If they're facing legal trouble, they will need to gauge how much cash to keep in reserve to cover their liability. Still, by their nature, estimates can leave room for doubt.

A Word of Warning

Since income statements do not always present the most precise figures, there is always a chance of misrepresentation. Whether it's by intent or by chance, numbers can be fudged. In crafting an income statement, figures may be used that are too high or too low. When you read them, you have no real way of knowing the precise numbers. Nor can you know for certain whether there are any sneaky motives at work.

Although estimates are needed, and mistakes can happen without foul play, they can also happen on purpose. There are many reasons a business would want to express an increase or decrease in figures such as losses or profits, and if they do so without the solid numbers to back up their claims, this is fraud.