How Parts of the Financial Statements Fit Together

A Summary of Accounting Relations

The Balance Sheet

Assets
- Liabilities
=Shareholders' equity


The Income Statement

Net revenue
- Cost of goods sold
= Gross margin
- Operating expenses
= Operating income before interest and taxes (ebit)
- Interest expense
= Income before taxes
-  Income taxes
= Income after tax and before ordinary items
+ Extraordinary items
= Net income
- Preferred dividends
= Net income available to common


Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement)

Cash flow from operations
+ Cash flow from investing
+ Cash flow from financing
= Change in cash


Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement)

Beginning equity
+ Comprehensive income
- Net payout
= Ending equity

Net Income
+ Other comprehensive income
= Comprehensive income

Dividend
+ Share repurchases
= Total payout
- Share issues
= Net payout

Find Investment Quality In The Income Statement

Find Investment Quality In The Income Statement
by Richard Loth (Contact Author | Biography)

To a large degree, it is the quality and growth of a company's earnings that drive its stock price. Therefore, it is imperative that investors understand the various indicators used to measure profitability. The income statement is the principal source of data to accomplish a profitability analysis, which should cover at least a five-year period in order to reveal trends and changes in a company's earnings profile. (To learn more basics on the income statement, see Understanding The Income Statement.)

 

Accounting Policies
With regard to the income statement, investors need to be aware of two things related to a company's accounting practices. First, the degree of conservatism, which indicates the degree of investment quality. The presentation of earnings depends, basically, on three accounting policies:

• revenue recognition,
• inventory valuation and
• the depreciation method.

Briefly stated, a completed sale, last in, first out liquidation (LIFO) rather than first in, first out liquidation (FIFO) valuation, and shorter-term depreciation periods, respectively, would produce higher quality reported earnings. (For related reading, see Inventory Valuation For Investors: FIFO And LIFO.)

 

Investors will be alerted to any changes and their impact on performance figures in a company's accounting policies in the notes to financial statements. Investors need to read these qualifying remarks carefully.

 

Sales
While the so-called "bottom line" (net income) gets most of the attention from financial analysts and investors in any discussion of profit, the whole earnings process starts with a company's revenue, or net sales. The growth of this "top line" figure is a key component in producing the dollars needed to run a company profitably. A healthy sales growth rate generally defines a growing company and is a positive investment indicator.

 

For investors, all sales increases are good and can occur as a result of sales growth through

• more unit volume from existing products/services,
• the introduction of new products/services,
• price increases,
• acquisitions and,
• for international sales, the impact of favorable exchange rates.

However, some increases should be viewed more favorably than others. There's no question that

• greater unit volume is the best growth factor,
• followed by product-line expansion and
• new services.

Price increases, especially those above the inflation rate, have their limits, as does sales growth through acquisitions. As applied to companies with foreign operations, the currency translation effect into U.S. dollars, either positive or negative, will even out over time.

 

Positive investment quality in the sales account comes from growth in better unit volume and the maintenance of reasonable pricing.

 

Margin and Cost Analysis
In the income statement, the absolute numbers don't tell us very much. A simple vertical analysis (common size income statement) - dividing all the individual income and expense amounts by the sales amount - provides profit margin and expense percentages (ratios) for the whole income statement. Looked at over a period of five years, an investor will have a clear idea of the consistency and/or positive/negative trends in a company's management of its income and expenses. The success, or lack thereof, of this important managerial endeavor is what determines, to a large extent, a company's quality of earnings. A large growth in sales will do little for a company's profitability if costs grow out of proportion to revenues.

 

The term margin is used to express the comparison of four important levels of profit in the income statement - gross, operating, pretax and net - to sales. Aside from monitoring a company's historical profit performance, these profit margins (ratios) also can be used to compare a company's profitability metrics to those of its direct competitors, industry figures and the general market.

 

Unusual Items
Also known as special, extraordinary or non-recurring, these items, generally charge-offs, are supposed to be one-time events. When they are, investors must take these unusual items, which can distort evaluations, into account, particularly when making inter-annual profit comparisons.

 

Unfortunately, in recent years, companies have been taking so-called "big-bath" write-offs with such regularity that they are becoming commonplace rather than unusual. Large multi-year charges on the income statement are increasingly distorting corporate earnings. Needless to say, evidence of undue use of major charge-offs is not indicative of investment quality. This practice is another reason why some financial analysts prefer to work with operating and pretax income numbers to evaluate a company's earnings, thereby eliminating the distortions of unusual items to net income. (To continue reading manipulating the books, see Cooking The Books 101.)

 

Traditional Profit Ratios
In addition to profit margin ratios, the return on equity (ROE) and return on capital employed (ROCE) ratios are widely used to measure a company's profitability. ROE measures the profits being generated on the shareholders' investment. Expressed as a percentage, the ROE ratio is calculated by dividing net income (income statement) by the average of shareholders' equity (balance sheet). As a rule of thumb, ROE ratios of 15% or more are considered favorable.

 

The ROCE ratio expands on the ROE ratio by adding borrowed funds to equity for a figure showing the total amount of capital being used by a company. In this way, a company's use of debt capital is factored into the equation. For this reason, conservative analysts prefer to use the ROCE ratio as a more comprehensive evaluation of how well management is using its debt and equity capital. This percentage ratio will vary among companies, but suffice it to say, that investment quality is represented by a higher rather than a lower figure. (To read more, see Spotting Profitability With ROCE, Measuring Company Efficiency and Keep Your Eyes On The ROE.)

 

The impact of leverage is picked up in the return on capital (return on invested capital or ROIC) ratio. (To read more, check out Spot Quality With ROIC.)

 

Earnings Per Share
While an absolute increase in net income is a welcome sight, investors need to focus on what each share of their investments are producing. If increased net income comes as a result of profits from increased share capital, then earnings per share (EPS) is not going to look so great, and could fall below the previous year's level. An increase in a company's capital base dilutes the company's earnings among a greater number of shareholders. (To learn more, read Types Of EPSand How To Evaluate The Quality Of EPS.)

 

 

Because of this circumstance, a company's net income, or earnings per share, is expressed as basic and diluted. The former represents EPS as of the balance sheet date as per the number of actual shares outstanding and net income as of a certain date, which is generally the company's fiscal year-end. Diluted EPS captures the potential amount of shares that could be outstanding if all

• convertible bonds,
• stock options and
• warrants were exercised.

While such a consequence is highly unlikely, it is possible. In terms of the investment quality of the income statement, a significant spread between basic and diluted EPS should be seen as a negative sign.

 

Conclusion

• Logic tells us that growing, profitable companies are generally attractive investment opportunities.
• However, how that growth is achieved is more important than the absolute sales and income numbers.
• In addition, conservative accounting policies, substantive sales growth, consistent and/or improving profit margins, the absence of outsized write-offs, above average returns on equity and capital employed, and solid earnings per share performance are the hallmarks of top-level investment quality.
• It is this set of attributes that investors should attempt to find in the income statement before they invest.

 

by Richard Loth, (Contact Author | Biography)

 

Richard Loth has more than 38 years of professional experience in the financial services sector, including banking, investment consulting and capital markets development, both internationally and in the U.S. He has worked with Citibank, Fleet National Bank and the Bank of Montreal. Mr. Loth is currently the managing principal of Mentor Investing, an independent Registered Investment Adviser based in Eagle, Colorado. Over the years, he has authored several investment education articles, publications, and books.

 

http://www.investopedia.com/articles/stocks/06/advincome.asp

Income Statement Accounts (Multi-Step Format)

Income Statement Accounts (Multi-Step Format) 

Net Sales (a.k.a. sales or revenue): These all refer to the value of a company's sales of goods and services to its customers. Even though a company's "bottom line" (its net income) gets most of the attention from investors, the "top line" is where the revenue or income process begins. Also, in the long run, profit margins on a company"s existing products tend to eventually reach a maximum that is difficult to improve on. Thus, companies typically can grow no faster than the growth of their revenues.

  

Cost of Sales (a.k.a. cost of goods (or products) sold (COGS), and cost of services):

• For a manufacturer, cost of sales is the expense incurred for raw materials, labor and manufacturing overhead used in the production of its goods. While it may be stated separately, depreciation expense belongs in the cost of sales.
• For wholesalers and retailers, the cost of sales is essentially the purchase cost of merchandise used for resale.
• For service-related businesses, cost of sales represents the cost of services rendered or cost of revenues.

(To learn more about sales, read Measuring Company Efficiency, Inventory Valuation For Investors: FIFO And LIFO and Great Expectations: Forecasting Sales Growth.)

  

Gross Profit (a.k.a. gross income or gross margin): A company's gross profit does more than simply represent the difference between net sales and the cost of sales. Gross profit provides the resources to cover all of the company's other expenses. Obviously, the greater and more stable a company's gross margin, the greater potential there is for positive bottom line (net income) results.

  

Selling, General and Administrative Expenses: Often referred to as SG&A, this account comprises a company's operational expenses. Financial analysts generally assume that management exercises a great deal of control over this expense category. The trend of SG&A expenses, as a percentage of sales, is watched closely to detect signs, both positive and negative, of managerial efficiency. 

Operating Income: Deducting SG&A from a company's gross profit produces operating income. This figure represents a company's earnings from its normal operations before any so-called non-operating income and/or costs such as interest expense, taxes and special items. Income at the operating level, which is viewed as more reliable, is often used by financial analysts rather than net income as a measure of profitability. 

Interest Expense: This item reflects the costs of a company's borrowings. Sometimes companies record a net figure here for interest expense and interest income from invested funds.

  

Pretax Income: Another carefully watched indicator of profitability, earnings garnered before the income tax expense is an important step in the income statement. Numerous and diverse techniques are available to companies to avoid and/or minimize taxes that affect their reported income. Because these actions are not part of a company's business operations, analysts may choose to use pretax income as a more accurate measure of corporate profitability. 

Income Taxes: As stated, the income tax amount has not actually been paid - it is an estimate, or an account that has been created to cover what a company expects to pay.

  

Special Items or Extraordinary Expenses: A variety of events can occasion charges against income. They are commonly identified as

• restructuring charges,
• unusual or nonrecurring items and
• discontinued operations.

These write-offs are supposed to be one-time events. When they are of this nature, investors need to take these special items, which can distort evaluations, into account when making inter-annual profit comparisons. 

Net Income (a.k.a. net profit or net earnings): This is the bottom line, which is the most commonly used indicator of a company's profitability. Of course, if expenses exceed income, this account caption will read as a net loss. After the payment of preferred dividends, if any, net income becomes part of a company's equity position as retained earnings. Supplemental data is also presented for net income on

• the basis of shares outstanding (basic) and
• the potential conversion of stock options, warrants, etc. (diluted).  

Comprehensive Income: The concept of comprehensive income, which is relatively new (1998), takes into consideration the effect of such items as

• foreign currency translations adjustments,
• minimum pension liability adjustments, and
• unrealized gains/losses on certain investments in debt and equity.

The investment community continues to focus on the net income figure. The aforementioned adjustment items all relate to volatile market and/or economic events that are out of the control of a company's management. Their impact is real when they occur, but they tend to even out over an extended period of time.

 

 

http://www.investopedia.com/articles/04/022504.asp

Understanding The Income Statement

Two basic formats for the income statement are used in financial reporting presentations - the multi-step and the single-step, which are illustrated below in two simplistic examples:


Multi-Step Format
Net Sales
Cost of Sales
Gross Income*
Selling, General and Administrative Expenses (SG&A)
Operating Income*
Other Income & Expenses
Pretax Income*
Taxes
Net Income (after tax)*

In the multi-step income statement, four measures of profitability (*) are revealed at four critical junctions in a company's operations - gross, operating, pretax and after tax.
In the single-step presentation, the gross and operating income figures are not stated; nevertheless, they can be calculated from the data provided.

Single-Step Format
Net Sales
Materials and Production
Marketing and Administrative
Research and Development Expenses (R&D)
Other Income & Expenses
Pretax Income
Taxes
Net Income

In the single-step method, sales minus materials and production equal gross income. And, by subtracting marketing and administrative and R&D expenses from gross income, we get the operating income figure. If you are a do-it-yourselfer, you'll have to do the math; however, if you use investment research data, the number crunching is done for you.

One last general observation: Investors must remind themselves that the income statement recognizes revenues when they are realized (i.e., when goods are shipped, services rendered, and expenses incurred). With accrual accounting, the flow of accounting events through the income statement doesn't necessarily coincide with the actual receipt and disbursement of cash; the income statement measures profitability, not cash flow.

----
Sample Income Statement


Now let's take a look at a sample income statement for company XYZ for FY ending 1998 and 1999 (expenses are in parentheses):

Income Statement For Company XYZ
FY 1998 and 1999
(Figures USD)
1998 1999
Net Sales
1,500,000 2,000,000
Cost of Sales
(350,000) (375,000)
Gross Income
1,150,000 1,625,000
Operating Expenses (SG&A)
(235,000) (260,000)
Operating Income
915,000 1,365,000
Other Income (Expense)
40,000 60,000
Extraordinary Gain (Loss)
- (15,000)
Interest Expense
(50,000) (50,000)
Net Profit Before Taxes (Pretax Income)
905,000 1,360,000
Taxes
(300,000) (475,000)
Net Income
605,000 885,000

Now that we understand the anatomy of an income statement, we can deduce from the above example that between the years 1998 and 1999, Company XYZ managed to increase sales by about 33%, while reducing its cost of sales from 23% to 19% of sales.


Consequently, gross income in 1999 increased significantly, which is a huge plus for the company's profitability. Also, general operating expenses have been kept under strict control, increasing by a modest $25,000. In 1998, the company's operating expenses represented 15.7% of sales, while in 1999 they amounted to only 13%, which is highly favorable in view of the large sales increase.

As a result, the bottom line - net income - for the company in 1999 has increased from $605,000 in 1998 to $885,000 in 1999. The positive inter-annual trends in all the income statement components, both income and expense, have lifted the company's profit margins (net income/net sales) from 40% to 44%, which is a highly favorable.


Conclusion

When an investor understands the income and expense components of the income statement, he or she can appreciate what makes a company profitable. In the case of Company XYZ, it experienced a major increase in sales for the period reviewed and was also able to control the expense side of its business. That's a sign of a very efficient management effort.

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