The income statement is the first statement up for a closer look in my three part series of financial statements. This will be my toolkit series of what you need to understand in order to read business figures and what they mean. This will be a longer post, so you may want to watch some Youtube videos on the topic to deepen your understanding.
The First of the Three
Public companies are obligated to release financial statements in their quarterly and annual reports. The three main ones are: the income statement, the balance sheet and cash flow statement. I will write three posts on each, because you need to understand these in order to evaluate a business. I will be paraphrasing Investopedia here, since it’s a great source for almost all financial terminology.
The income statement (sometimes referred to as proft and loss statement) focuses on revenues and expenses during a particular period. It reports income through a particular time period and its heading indicates the duration, which may read as “For the (fiscal) year/quarter ended September 30, 2018.”
The statement focuses on the four key items – revenue, expenses, gains and losses. It does not cover receipts (money received by the business) or the cash payments/disbursements (money paid by the business). It starts with the details of sales, and then works down to compute the net income and eventually the earnings per share (EPS). Essentially, it gives an account of how the net revenue realized by the company gets transformed into net earnings (profit or loss).
Since the purpose of this blog is to simplify these terms for the layman, I’m going to go through parts of the income statement on what I personally focus on.
What to Look For
DISCLAIMER: THIS IS NOT FINANCIAL ADVICE, ALL OPINIONS EXPRESSED ARE MY OWN, I AM NOT A FINANCIAL ADVISOR. THE ADVICE HERE GIVEN IS NOT FINANCIAL ADVICE EVEN THOUGH MY EXCITEMENT MIGHT MAKE IT LOOK LIKE SUCH.
First, look at the revenue. Compare the current year to previous years. Is it going up? Down? Generally, you want the trend to be upward year over year. If it’s going up through the years, figure out why. This information will most likely be found in past annual reports in shareholder letters.
Next, I look at Operating Income. This is how much the company has made from it’s regular business operations. Preferably, this number should also be going up over the years. If this number is fluctuating, it may be harder to evaluate the business. Find out the operating margin, which is: operating income / Revenue. This will tell in percentages how much of the revenue comes from regular business activities (the bread and butter). Generally, I like to see a consistent number of 10% or more (15% and above is excellent). Remember, these numbers are arbitrary and of course vary between industries. A low number does not mean the company is inherently bad. If a company has a lower margin, but it has been growing over the years, this may indicate positive tailwinds for the business. But still, the higher, the better.
Finally, if revenue and operating income is trending upwards, all things being equal this should translate into rising net income, and thus earnings per share. Figure out the Net Margin (net income / revenue) and look at its development in years past. This gives the percentage of what the net income is out of the total revenue. I prefer a number of 5% or more. A company in a high growth phase might report record year over year revenue growth, but over time high growth rates have to transform into earnings at some point, or the business will have a hard time surviving.
Conclusion
I try to adhere to the philosophy “Value and growth are joined at the hip”. You want a company that will grow over the long-term, but you want to pay as little as possible. I’ll end this post with a video from one of my favorite investor-youtuber’s video explaining the income statement further.
Now that the income statement is covered, we move on to the balance sheet.
-IGTSKasimir
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