ROLE OF THE INCOME STATEMENT IN FUNDAMENTAL ANALYSIS
The first financial statement an investor would first look through is the Income statement in an annual report or Securities and Exchange Commission (SEC) filing.
The figures that are shown when a company announces its results are revenue, earnings, and earnings per share. In other words, the income statement is a statement showing how much money company has generated over a period of time, how many expenses it has made and the difference between revenue and expense, that is, profit.
In fundamental analysis, evaluating the income statement is an important step as an investor can be aware of the company’s business and its stability through the income statements. The income statements convey whether the company is making money or not. Companies that have low expenses related to the revenue and make high profits related to revenue are often likely to stay in business for long and hence considered financially strong by the investors.
Revenue or, also known as sales, is usually directly mentioned in the income statement. Generally, there is a single number showing all the revenue or money that was brought in by a company. However, this may be bifurcated into business segments or any other, by some big companies.
It is known that the best way companies intend to increase their profitability is by increasing their sales. However, an investor must be aware that revenues of a company must continue year in and year out and not just be temporary increases. Temporary increases involving short term promotions or more can be less essential for the investors as they affect earnings per share of the company as well.
There are several types of expenses that a company incurs but most common among them are Cost of goods sold (COGS) and selling, general and administrative expenses (SG&A). Cost of goods sold includes the cost of producing or purchasing the goods and services which are ultimately sold by the company.
Selling, general and administrative expenses involve marketing, salaries, utility bills, technology expenses and other costs concerned with running a business. Depreciation and amortization are also included in this head. Some corporate expenses are important for the future growth of the company and hence must be considered by the investor. Other financial costs, taxes, and interest payments are also to be paid due attention.
Total revenue minus total expenses give a company’s profit. Performance of a company can be examined by some profit subcategories.
Gross profits are calculated by subtracting the cost of sales from revenue. Companies with higher gross margins are expected to spend more on business operation such as R&D or marketing. Hence, investors should keep a check on the downward trend in the gross margin rate over a period of time.
Operating profit is revenues minus the cost of sales and SG&A. Operating profit shows the profit made by a company from actual operations, excluding revenue and expenses that are not related to central operations. High operating margins imply that company holds potent control of costs and sales are increasing at a faster rate than operating costs. Investors can scrutinize and compare operating profit with other companies’ operating profit. Operating profit is considered an authentic source of showing profitability as it aims to measure how much cash is thrown off by the business and it becomes difficult to exploit with accounting tricks than net earnings.
Net income shows the company’s profit after paying off all the expenses. This is the amount investors can look at to recognize the profits or earnings of a company.
Companies tend to have an edge over its competitors whenever it has a high-profit margin since with high net profit margins, companies are capable of getting rid of the hard times and sustaining. They also have the potential to increase their market share in the hard times, hence making themselves strong for future conditions. Whereas, companies with low-profit margins can come to an end in a downturn.
Investors can acquire enough information about a company by analysing its income statement. Increasing sales often tends to be a strong fundamental of a company. Whereas, efficiency and profitability of a company can be computed by rising margins. Comparison of a company with its competitors can provide valuable information to investors.