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 The income statement is the financial statement that allows a business as well as investors to understand if a company is operating successfully. The income statement is often used to help value a company's stock and it's also used by credit rating agencies to determine the creditworthiness of a company.
In this publication we're going to first review some of the basic information that appears on an income statement. Then we're going to talk a little bit about the limitations, or weaknesses of this statement. Finally, we're going to summarize what we believe are the strengths of the income statement and how this information can be used to help value a market security.
Income Statement Basics
The income statement is the financial statement used to provide information on the revenues, expenses and ultimately the profitability of a company. A simplified way to express the information appearing on this statement is:
+ Revenues
- Expenses
= Net Income
By understanding the relationships between these three values users of financial statements have a way to analyze the interactions between sales, operating costs, and profitability. We're going to talk about those interactions in more detail later on during our discussion dealing with analyzing information that appears on income statements.
Limitations of the Income Statement
While there are many reporting standards that are in-place such as GAPP (generally accepted accounting principles) as well as guidance published by the FASB (Financial Accounting Standards Board) this does not necessarily mean the income statement is without its limitations. In fact, there are at least two weaknesses of the statement:
- Limited to Accounting Data Only
- Accounting Methods Vary
Each of these limitations is explained in more detail below.
Accounting Data Limitation
One criticism of the income statement has to do with the fact it does not tell the user anything about what might happen in the future. By its very nature, the income statement provides a glimpse into the history of the company's operations.
The income statement also doesn't provide the analyst with any information about factors that might affect the future growth of the company. New products in the pipeline, market expansion, competitive advantages - none of these factors appear on the income statement since it is limited to accounting data.
Income Statements and Accounting Methods
The second limitation of the income statement has to do with the flexibility that company's have with respect to choosing an acceptable accounting method. Depreciation is a good example of how the chosen accounting method can affect net income.
For example, if the company decides to accelerate depreciation then they hurt short-term net income and earnings (depreciation expense is larger). If they use straight line depreciation, net income in earlier years will be higher - but it will be lower in the future (all things being equal).
Market analysts pay careful attention to these details because it can tell them a lot about the quality of earnings - has a company chosen to use more liberal accounting methods to increase short-term performance? It happens all the time.
Valuing Companies Using the Income Statement
Even with all of its limitations, the income statement is a very important financial document when it comes to valuing securities or getting a feel for the creditworthiness of a company. With that in mind, we're going to break down this valuation section into two parts:
- Analysis by Shareholders
- Analysis by Creditors
Each of these approaches is discussed in more detail below.
Income Statement Analysis by Shareholders
When investors analyze a stock the first, and arguably most important, factor they look at is earnings - usually in terms of earnings per share. They are also going to look at certain financial ratios such as dividend yield, price to earnings ratio (P/E ratio), operating expense ratio, and return on investments.
Each of these measures can be found by analyzing the income statement. The following is a brief overview of each measure.
Earnings Per Share
Earnings per share (EPS) is defined as the net income (or profits) of a company divided by the shares of common stock outstanding. So with earnings per share you are looking at the amount of money left over for shareholders - after taxes - and "normalizing" those profits by stating them on a per share basis.
Earnings per share can be calculated using the following formula:
(Net Income - Preferred Dividends) / Shares of Stock Outstanding
Price to Earnings Ratio
The price to earnings ratio or P/E ratio is the stock's price divided by the latest 12 months of earnings per share. The P/E ratio is an indicator of the premium you'll be paying for a stock and is also an indicator of future growth expectations. In general, the lower the P/E ratio, the better because a high P/E ratio indicates you're paying a premium for the stock's "potential" future earnings.
You can calculate price to earnings ratios using:
Market Value of Stock / Earnings per Share
Dividend Yield
While dividends are important to some investors they are often a secondary consideration to others. Those that cherish dividends are usually interested in receiving a steady stream of cash dividends each year.
Those that are less concerned about dividends are usually seeking out stocks that are reinvesting in their company and have adopted a growth strategy. These investors are seeking stock price appreciation and capital gains.
Dividend yield is calculated in the following manner:
Market Value of Stock / Dividends per Share
So the dividend yield shows us the rate earned based on the current market value of the company's stock.
Operating Expense Ratio
The operating expense ratio is a measure that is often used to figure out how well a company is able to control their operating expenses. The operating expense ratio is a good example of a comparative measure - meaning you'd want to analyze this measure using a comparative income statement (one containing multiple years) and examine the trend in operating expense ratio.
Operating expense ratio is calculated using the following formula:
Operating Expense / Net Sales
The lower the ratio, the better the company is performing. So a favorable trend would be one where the ratio is declining, while an unfavorable trend would be one where the ratio is increasing.
Return on Investment
In this context, returns on investment are a measure of a company's ability to use their available resources efficiently. And while there are several measures of this type - each using a different divisor - the most useful measure is return on total assets.
Return on total assets is calculating using:
(Net Income + Interest Expense) / Total Average Assets
The total average assets can be found by adding the Total Assets at the beginning of the year and end of year to find the average for the year. Return on total assets is another example of a comparative measure.
Income Statement Analysis by Creditors
If you're going to lend someone money most of us want to be pretty sure that we're going to get our money back. The same rule holds true for creditors - they're investing in a company by lending them money and these same creditors can use the income statement to get a good feel for whether or not a company is in good enough financial condition to repay the money.
From the company's standpoint they are willing to borrow money as long as the rate of return earned on that money is higher than the cost of borrowing. When this occurs (rate of return > cost to borrow) then shareholder benefit by this use of leverage.
Leverage is simply buying assets with money raised by borrowing or by issuing preferred stock. The downside of leverage occurs when the rate of return on an investment is lower than the cost of borrowing. When this happens, leverage lowers net income and therefore earnings per share.
Times Interest Earned
We discuss several different measures of leverage in our article on Understanding Financial Ratios. That being said, there is one very important leverage measure that can be found by examine the income statement - times interest earned.
The number of times interest earned is a measure of how "easy" it is for a company to cover its debt payments. This measure is also called the interest coverage ratio or coverage ratio.
You can calculate times interest earned from the income statement using:
Net Income / Annual Interest Expense
This ratio should always be above 1.0 and the higher the ratio the better. If a company has no debt then you cannot calculate this measure and leverage is not a concern.
Summarizing Income Statement Analyses
This article was very focused on the topic of analyzing income statement information. We've talked about the strengths and weaknesses of the statement as well as the financial ratios that can be calculated using information appearing on this statement.
It's also a supplemental article to out publication on Understanding Net Income where we explain all of the elements appearing on the income statement. Next up we're going to finish up this series with a discussion of how to construct an income statement.
About the Author - Analyzing Income Statements
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