| In today's article, we'll be looking at the income | | | | advantage on most investors. A majority of |
| statement, which is the most deceptively simple | | | | individual investors simply skip this part, and go |
| of the major financial statements. I say simple | | | | right to calculating ratios or looking at the EPS. |
| because it's just a list of all the revenue, minus all | | | | Seasoned investors know that the MD&A |
| the expenses, to calculate what's left over in | | | | provides the backup data for the income |
| profit. It's no more difficult than putting your | | | | statement line items, and they will take time to |
| family budget together, right?That's where the | | | | read it.A good Management Discussion and |
| deceptive part of the description comes in. The | | | | Analysis will give you the details you need to |
| items on the income statement are easily | | | | understand the items on the income statement. |
| manipulated by, say, less-than-honest | | | | You should get segmented sales data, cost |
| management, and don't necessarily represent the | | | | drivers, etc. in this section. If you can't make |
| true situation at a company. Even totally honest | | | | sense of the MD&A, that should set off alarm |
| companies can have income statements that | | | | bells in your head. If you don't find the information |
| don't represent economic reality. Cash flows | | | | you need in the MD&A, you should...4. Look at the |
| define economic reality, revenue and expenses | | | | Notes to Consolidated Financial Statements |
| define accounting reality.You see, the difference | | | | (Footnotes)The footnotes tend to be more |
| between your household budget and a company's | | | | difficult to understand than the MD&A, but you |
| income statement is their relationships to actual | | | | get really detailed information here. The footnotes |
| cash flows. Your household budget will generally | | | | are where management hides the dirty laundry. |
| match your cash inflows and outflows. Not so | | | | And when you've got guys making today's |
| with an income statement. Income statements | | | | corporate salaries that laundry pile can get pretty |
| can vary significantly from the company's cash | | | | big. Here's where you'll likely find what you couldn't |
| flow, meaning that a company in economic trouble | | | | in the MD&A, it's just that in the notes you may |
| can show a very "good" income statement up | | | | have to do some putting of two and two |
| until the day it goes bankrupt.Generally speaking, | | | | together.Take your time sifting through this |
| though, the income statement is a good place to | | | | section, and try to identify the income statement |
| start when evaluating a company. In my | | | | items that relate to the footnotes you're reading. |
| forthcoming e-book, Fundamentals of Financial | | | | You can do it the other way around, as well, and |
| Statement Analysis, I lay out the process for | | | | look for the footnotes that relate to the income |
| evaluating the health of a company through the | | | | statement item.If you still can't figure out what |
| financial statements. I'm shooting for publication in | | | | the company is doing, after going through the |
| the beginning of 2004, but in the meantime, here | | | | MD&A and the footnotes, you may want to |
| are some tips and strategies for evaluating an | | | | consider looking at another company. This one |
| income statement.1. Create a Common Size | | | | may be too complicated (or too devious) for your |
| StatementWhat's a common size statement, you | | | | abilities. Don't feel bad about not understanding the |
| ask? It's the income statement, only with each | | | | business, either. Even the great Warren Buffett |
| line item represented as a percentage of sales. | | | | admits that he doesn't understand some |
| This is easy to do with a spreadsheet on your | | | | businesses, and he never lets his ego run away |
| computer, but you can do it on paper just as well. | | | | from him. If he can't understand it, he won't |
| Net Sales is always 100% at the top, and each of | | | | invest in it. I recommend you do the same thing.5. |
| the expenses is divided by total sales to arrive at | | | | Look at segmented dataI always like to look at |
| a percentage. For example, if a company has | | | | segmented sales and profit figures to determine |
| $100 in sales and $50 in cost of goods sold, the | | | | which product lines, or operating businesses, are |
| common size statement will look like this:Sales | | | | growing sales faster than the others. This |
| 100%Cost of Goods Sold 50%Gross Profit | | | | information is usually in the MD&A. If you can, try |
| 50%The importance of the common size | | | | to find the operating profit for each business |
| statement can't be overstated. It gives you the | | | | segment as well. Then look at the profit margins |
| calculation of all your profit margins, from gross | | | | for each segment of the business.You may be |
| to net, and shows how much each cost item | | | | surprised at the different profitability levels of |
| takes away from your profits.2. Create a | | | | each business segment. Compare the segment |
| Year-to-Year Comparison StatementThe next | | | | with the fastest growing sales versus the |
| step is to make a year-to-year comparison | | | | segment with the highest operating profit. If |
| statement. You can't evaluate financial statements | | | | these are the same segment, that's good news. |
| for just a single year; they have to be compared | | | | If they aren't, that's okay too.You do want to |
| to previous years. The only formula you need to | | | | watch out for companies that have the lowest |
| know for these calculations is:(current year / | | | | operating profit in their fastest growing segment. |
| previous year) - 1 = % changeAgain, a | | | | This could cause a decline in the company's overall |
| spreadsheet makes this process so much easier, | | | | profitability as sales grow faster than profits. For |
| but it can be done by hand. I like to have five | | | | example, a segment that's growing 5% a year, |
| years of data, which yields four years of | | | | but has a 10% margin, will contribute more to |
| comparison data. This way you aren't just looking | | | | total operating profit growth than a segment |
| at an exceptionally good or bad year for the | | | | growing at 20% a year with a 1% margin.I hope |
| analysis. Plus, you can get a reasonable estimate | | | | you find these tips helpful. Of course, there are |
| of future growth when you do your discounted | | | | plenty of other analysis tools that you can use to |
| cash flow analysis. (I'll have more on the | | | | evaluate financial statements. It's important that |
| Discounted Cash Flow in the future.)3. Read the | | | | you keep looking for more and better ways to |
| Management Discussion and AnalysisIf you take | | | | analyze company data, because constant learning |
| the time to read the MD&A, you'll have an | | | | will make you a consistently better investor. |