The financial statements are very often overlooked by most private investors at their peril. We would not buy a house before viewing it, checking for damp, and making sure it is structurally sound. Stock market investing is no different. It is important that we know what is going on before we actually buy a stock, because we don’t want to discover that the company has debt only when the bank calls it in, and the company goes bankrupt. Understanding a company’s finances will allow us to make the right decisions when investing and help us to know better what we own.
What Is The Income Statement?
The income statement, or consolidated statement of comprehensive income, shows what the company has made in terms of revenue and how much of that is profit for the company and its shareholders. Other names include the profit and loss statement, or the P&L.
Below is the top half of an income statement. The income statement gives us three columns, the far right column being the full year audited results, and the other two columns being six months for the period ended for the current year and the previous year in order to compare.
Having the previous year’s full results helps because in this instance we can see that the company is on track at the halfway point to beat last year’s revenue target. We can also compare the growth from the same period last year too.
What Is Revenue/Turnover?
At the top of the income statement is the revenue, or turnover, which is known as ‘top line’ growth.
Revenue is the money earned from sales but before the costs have been taken off. For example, if we have a coffee wagon and sell ten coffees for £2.00 and make £20.00 – then £20.00 would be our revenue. We haven’t taken off our costs of the coffee itself to sell to our customers. That comes next.
What Is Cost Of Sales?
From revenue we move down to the expenses, or cost of sales, which is then deducted from revenue to give us our ‘Gross profit’. Our cost of sales is everything that is involved in the product itself. In the case of our coffee wagon it’s the coffee and milk, and for a carpenter it would be the wood. Cost of sales is the raw materials needed to deliver the product or service. We wouldn’t include the cost of our wagon or the carpenter’s tools because these are different costs which acknowledged on the income statement later.
What Is Gross Profit?
Gross profit is a very basic measure of profitability and can be used when comparing companies in the same sector to analyse their gross margins. Gross profit uses only the pricing power and the cost of materials and so does not include everything else required for the business to function.
How Do I Calculate Gross Margin?
To calculate the gross margin, we need to take the gross profit and divide this by our revenue, to tell us what percentage of our revenue we are converting to gross profit.
Gross margin = (revenue – cost of sales / revenue)
If we divide 8,561 by 22,338 this gives us 0.38 which is a gross margin of 38%.
However, gross margin is only useful to compare when looking at the power of the brand or the efficiency of its purchasing power. A company that commands a significantly higher gross margin than its competitors is able to do so because it is either charging a higher market price for its products or services or they have a very good arrangement with their suppliers (or both!).
What Is Operating Profit And Why Is It Important?
After gross profit, we need to take away distribution costs and administrative expenses. The distribution costs are the money the company needs to pay to get its product in front of its consumers, and the administrative expenses consists of all other costs such as rent, running costs, and salaries. They are costs that are not directly involved in the manufacturing process in this example, and will also include marketing costs, office costs (telephones, internet), travel etc.
By taking both of these costs away we are left with ‘Operating profit’. This is a much better comparison than gross margin in sectors because operating profit not only takes into account the cost of sales but the costs of everything required in order to produce a profit once all costs have been included.
Operating profit is a much better comparison between companies in the same sector because it factors in all of the costs necessary for the company to run, or operate. However, just because a company generates healthy operating profit does not mean that they will be profitable…
From operating profit, it is relatively easy to get to net profit / net income. Here is the second half of the income statement:
What Is Net Profit?
Net profit, or net income, is the bottom line figure on a balance sheet, that is the final amount left to shareholders of the company after all other costs.
Any financing costs must be taken away from operating profit, before we reach profit before tax. Financing costs in this instance is debt repayment and this is where the tax shield can come in handy, because a company that finances itself with debt can use those debt repayments against their total taxable profit before tax. Taking on debt can be riskier, but it prevents shareholder dilution and so debt has been attractive for companies looking to expand (especially in the last decade when interest rates have been at rock bottom).
Finally, after all necessary financing costs and taxation has been deducted, we see the net profit, or the bottom line. When people talk about the bottom line, this is what they are referring to, net profit after tax. This is the figure that we divide into the amount of shares in issue to achieve earnings per share.
Why Is Debt Financing Preferred Over Equity?
As equity holders, we would rather companies leverage themselves with debt rather than issuing equity for cash – so long as the debt is both sensible and manageable. Not only are these interest payments deductible from tax, but they protect us from dilution. Unless taking on too much debt would put the company at risk of blowing up, it should be our preferred option. That said, no debt and no dilution is even better.
Income Statement Check-Up
- Can the company benefit from operational gearing? Are the costs fixed or is there a cost per unit?
- Are financing costs eating too much into the profit?
- Is revenue growing year on year?
- Are gross margins rising or falling – if falling why?
- Is profit growing year on year?
- Are there any exceptional items such as an asset sale listed which are giving a false representation of the true profitability of the company?
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