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Datamatrix - Analyzing Company Reports

Suite 406

ANALYZING COMPANY REPORTS


Fundamental Vs. Technical Analysis
Reading Annual & Quarterly Reports
Understanding Company Earnings
Understanding Balance Sheets
Balance Sheet Analysis
Understanding Income Statements
Income Statement Analysis


406.01           FUNDAMENTAL VS. TECHNICAL ANALYSIS 

Two types of data analysis have emerged to assist buyers and investors in making better investment decisions.  In this section, we will introduce you to fundamental and technical analysis.

  • What is a Fundamental Analysis?
  • What is a Technical Analysis?
  • Which type of analysis is better for you?

What is a Fundamental Analysis?

Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer.  It scrutinizes the issuer’s income and expenses, assets and liabilities, management, and position in its industry.  In other words, it focuses on the “basics” of the business.

If you want to use fundamentals to help you make an investment decision, you would rely heavily on an offering prospectus, annual and quarterly reports as well as any current news items relating to the issuer whose securities you are considering.

A technical analysis takes a different approach.

What is a Technical Analysis?

Technical analysis is a method used to evaluate the worth of a security by studying market statistics.  Unlike fundamental analysis, technical analysis disregards an issuer’s financial statements.  Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform.

If you want to use technical analysis to help you make an investment decision, you will refer to financial charts, tables and ratios found in the financial press.  You will look for market trends and averages to help you decide whether the “time is right” to make an investment.

Which Type of Analysis is better for You?

Fundamentalists and technicians have been at odds with one another since the advent of investing.  There is no clear answer as to which is right.  Sometimes it appears that the technicians make better picks.  Other times it seems the fundamentalists are making the right call.  One thing is certain, when one group of analysis is wrong the other will surely emerge saying, “We told you so”.  So, which is right for you?  There are many potential answers to that question.  Three variants of popular answers are:

If you are a “long-term” investor looking for companies with solid foundation, growth and income potential, the fundamentals may sway you.

If you are a “short-term” investor (trader) looking for companies who are “on the verge” of being discovered, fundamentals will be useful to you.

If you are a “long-term” investor who is not as concerned about one company’s basics because you will diversity to minimize risk, or you are a “short-term” investor waiting for investor sentiment to change, then technical analysis will be helpful to you.

Today, many investors find both fundamental and technical analysis helpful in painting a more complete and colourful picture on the investment canvas.  Whether you use an asset allocation, buy and hold, or market timing strategy, you will find useful information from both the fundamentalists and technicians.  The technicians can tell you about the broad market and its trends. The fundamentalists tell you whether an issue has the “basics” necessary to meet your investment objectives.

Both fundamental and technical analysis methods differ radically in their approaches.  Try using the bet ideas from each camp and you should be pleased with the results.


READING ANNUAL & QUARTERLY REPORTS

In the following section, we will look at the information available in corporate reports. 

406.02                       WHAT IS THE ANNUAL REPORT?

A company is required by law to provide its shareholders with information about its operations.  An annual report satisfies this obligation.

The information in an annual report shows the company finances.  It is extremely useful to investors because it allows them to use their own judgment on how well the company is doing and forecast is future earnings and dividends.  For an investor, this information is critical for making investment decisions.

You can also read the chairman’s letter about the company’s future goals.  Use caution with these letters since the author is a company representative.  You may want to look at how accurate this letter has been in the past to give you an idea how much you can rely on it.

Required Information

An annual report is a brief profile on the health of a company.  Here is what comprises an annual report:

  • A letter from the chairman on the high points of business in the past year with predictions for the next year.
  • The company’s philosophy: a section that describes how the company does business
  • An extensive report on each section of operations in the company.  This portion of the report may describe the services or the products that the business offers.
  • Financial information that includes the profit and loss (P&L) statements and a balance sheet.  The P&L statement describes income and expenses and gives the net profit for the year.  The balance sheet describes assets and liabilities and compares them to the previous year.  In this section, important information may be revealed in the footnotes.  They may discuss current or pending lawsuits or government regulations that have an impact on company operations.
  • An auditors’ letter confirming that all of the information provided in the report is accurate and been certified by independent accountants.

Keep in mind that the public relations department of the company produces the annual report.  The report should be very accurate with all the information described in the best possible manner.

406.03          HOW TO OBTAIN ANNUAL REPORTS

Annual reports are mailed automatically to all shareholders of record.  To obtain the annual report for a company in which you do not own shares, call the public relations (or shareholders relations) department of the company.  You may also look on the company Web site, or search the Internet.  There are several sources on the Internet providing information on public companies.  You can search the EDGAR database at www.sec.gov/edgarhp.htm, the Microsoft Investor Web site at www.investor.msn.com, the American Association of Individual Investors at www.aaii.org, or the Yahoo Financial Web site at www.finance.yahoo.com, to name a few.  Simply keying in the stock’s symbol will provide you with the needed information.

Quarterly and other Financial Reports

Besides the annual report, companies provide several other financial reports such as a quarterly report, 10k reports and statistical supplements.

Quarterly reports are very similar to the annual reports except they are issued every three months and are less comprehensive.  They may be obtained in the same way as an annual report.

Larger firm’s issue 10k reports that are more detailed than annual reports.  A 10k report provides detailed information about divisions and subdivisions of the company.  These reports are sent to stockholders only by request.  One should contact the company’s corporate secretary to receive a 10k.  All 10k filings are available on the EDGAR database at www.sec.gov/edgarhp.htm.

Statistical supplements are reports of larger corporations as well.  They provide financial information, such as statement data and key ratios, which can be dated back 10 to 20 years.  These reports are also posted on the EDGAR database.

 

UNDERSTANDING COMPANY EARNINGS

We will now discuss the following topics:

  • What Are Company Earnings?
  • Why Are Earnings Important to You as an Investor?
  • What Makes Up Corporate Earnings?
  • Where Do You Find Corporate Earnings Information?
  • How Do You Use Earnings Information to Make an Investment Decision?

406.04           WHAT ARE COMPANY EARNINGS?

You go into business to make money.  Unless an organization is a not-for-profit enterprise, its goal is to make money for the owners.  In order to make money, the business must have income to pay its employees, utility bills, costs of production and other operating expenses.  If a company has cash left over after paying its expenses, it has earnings.  Earnings are a company’s net profit.

The nature of a business defines how it makes earnings.  Two sources of company earnings are income from sales of goods or services and income from investment.  For example, a manufacturer produces goods for sale to its clients.  A bank sells depository services to its clients.  All businesses generate income by providing either goods or services to clients.

Another source of income is investment.  Investments generate income for businesses and individuals from either interest on loans, dividends from other businesses, or gains on the sale of investment property.

Company earnings are the sum of income from sales or investment after paying its expenses.  Sounds simple enough, but what does this have to do with you?

Why Are Earnings Important to You as an Investor?

If you invest in a company’s stock, you gain an undivided share of the company.  Typically, when a company earns more money, shareholders do as well.  So, company earnings are important to your because you make money when the business you invest in makes money.  When a company y you own stock in has positive earnings, it benefits you in several ways.

  • You may receive a portion of the earnings as a dividend.
  • The company may reinvest earnings for future growth.
  • The company may invest earnings to generate additional income.

In any case, earnings are important to your because they provide a company with capital to make money for you as an investor.

406.05           WHAT MAKES UP CORPORATE EARNINGS?

Income from sales and investments produce earnings.

Before a company can sell its product or service, it incurs expenses to produce them.  These expenses may include cost of materials, labor, market research, marketing, sales and distribution and overhead.  Before a company can show a profit, it must first settle the costs of doing business.

The way in which a business conducts its operations is an important element to understand when evaluating a company’s earnings.  Companies that are devoting significant resources to creating a new product may have relatively weak earnings now.  But, if that new product catches on, profits could quickly rise and the earnings may begin to soar.  Meanwhile, companies that have great earnings now, but are not investing any money to ensure that their business success will continue, may have significant problems in the future.

When evaluating corporate earnings you should not only look at the income sources, but the expenses as well.  They can reveal the company’s long-term strategy for making money, or uncover potential inefficiency or mismanagement.

Where Do You Find Corporate Earnings Information?

The best place to learn about company earnings is the corporate annual report.  The annual report contains information on the company philosophy and its position in the marketplace.  It also contains audited financial statements.  These tell you all about the company’s financial operations. You can obtain an annual report directly from the company’s public relations department or on the Web (in the U.S.A. by searching the Securities and Exchange Commission’s EDGAR database at www.sec.gov/edgarhp.htm.

To find information abut the company’s earnings, you should study the “income statement” and “balance sheet”.  The income statement shows the sources of a company’s income, production costs and other expenses.  The balance sheet shows the company’s overall financial strength and potential for growth.

406.06           WHAT WILL EARNINGS INFORMATION TELL YOU?

The “financials” will show you whether a company is oriented for income, growth, or a bit of both.  You can get all of this information from the financials.  But you must compare the financials for different companies in the same industry to see which has characteristics best suited to your investment goals.

A convenient way to compare companies is through earnings per share (EPS).  EPS represents the net profit divided by the number of outstanding shares of stock.

When comparing earnings per share of several companies that are candidates for your investment dollars, here are a few things to consider.

  • Companies with higher earnings are stronger than companies with lower earnings.
  • Companies that reinvest their earnings may pay low or no dividends, but may be poised for growth.
  • Companies with lower earnings, and higher research and development costs, may be on the brink of a breakthrough (or disaster).
  • Companies with higher earnings, lower cost and lower shareholder equity, may be a target for a merger.

When comparing different companies’ earnings you should ask yourself.

  • Why are they different?
  • Do the differences make sense for these companies?


UNDERSTANDING BALANCE SHEETS

In this section, we will learn the importance of a balance sheet.  We will cover what they represent, how to understand them and how they are presented.  We will also provide some useful equations and an example of a balance sheet.

406.07                       UNDERSTANDING THE BALANCE SHEET

In order to make an informed investment decision, you should review a company’s balance sheet.  Let’s look at what a balance sheet entails.

The balance sheet is one of the most important financial statements of a company.  It is reported to investors at least once per year.  It may also be presented quarterly, semi-annually or monthly.  The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities), and the value of the business to its stockholders (the shareholders’ equity).  The name, balance sheet, is derived from the fact that these accounts must always be in balance.  Assets must always equal the sum of liabilities and shareholders’ equity.

406.08                       WHY IS THE BALANCE SHEET SO IMPORTANT

The balance sheet is the fundamental report of a company’s possessions, debts and capital invested.  Before investing in any company, an investor can use the balance sheet to examine the following:

  • Can the firm meet its financial obligations?
  • How much money has already been invested in this company?
  • Is the company overly indebted?
  • What kind of assets has the company purchased with its financing?

These are just a few of the many relevant questions you can answer by studying the balance sheet.  The balance sheet provides a diligent investor with many clues to a firm’s future performance.  In this section, you will learn the basic building blocks necessary to do such analysis. Once you completely understand the balance sheet, making informed investment decisions should be much easier for you.

406.09                       THE BASIC CONCEPT BEHIND THE BALANCE SHEET

The concept behind the balance sheet is very simple.  In order to acquire assets, a firm must pay for them with either debt (liabilities) or with the owners’ capital (shareholders’ equity).  Therefore, the following equation must hold true:

Assets = Liabilities + Shareholders’ Equity

406.10                       WHAT ARE ASSETS?

Assets are economic resources that are expected to produce economic benefits for its owners.  Assets can be buildings and machinery used to manufacture products.  They can be patents or copyrights that provide financial advantages for their holder.  Let us begin with a look at a few of the important types of assets that exist.

Current assets are assets that are usually converted to cash within one year.  Bondholders and other creditors closely monitor a firm’s current assets since interest payments are generally made from current assets.  They include several forms of current assets:

  • Cash in known and loved by all.  It is the most basic current asset.  In addition to currency, bank accounts without restrictions, checks and drafts are also considered cash due to the ease in which one can turn these instruments into currency.
  • Cash equivalents are not cash but can be converted into cash so easily that they are considered equal to cash.  Cash equivalents are generally highly liquid, short-term investments such as U.S. government securities and money market funds.
  • Accounts receivable represent money clients owe to the firm as more and more business is being done today with credit instead of cash; this item is a significant component of the balance sheet.
  • A firm’s inventory is the stock of materials used to manufacture their products and the products themselves before they are sold.  A manufacturing entity will often have three different types of inventory: raw materials, work-in-process, and finished goods.  A retail firm’s inventory generally will consist only of products purchased that have not been sold yet.

Now that we have looked at some of the most important short-term assets, le us move forward to examine long-term assets.

Long-Term Assets

Long-term assets are grouped into several categories.  The following are some of the common terms you may encounter:

Fixed assets are those tangible assets with a useful life greater than one year.  Generally, fixed assets refer to items such as equipment, buildings, production plants and property.  On the balance sheet, these are valued at their cost.  Depreciation is subtracted from all except land.  Fixed assets are very important to a company because they represent long-term illiquid investments that a company expects will help it generate profits.

Depreciation is the process of allocating the original purchase price of a fixed asset over the course of its useful life.  It appears in the balance sheet as a deduction from the original value of the fixed assets.

Intangible assets are non-physical assets such as copyrights, franchise and patents.  To estimate their value is very difficult because they are intangible.  Often there is no ready market for them.  Nevertheless, for some companies, an intangible asset can be the most valuable asset it possesses.

Remember that every company will have different assets depending on its industry.  However, it is important to know and understand the major accounts that will appear on most balance sheets.  Now, we will talk about what the company owes to others: its liabilities.

406.11                       WHAT ARE LIABILITIES?

Liabilities are obligations a company owes to outside parties.  They represent rights of others to money or services of the company.  Examples include bank loans, debts to suppliers and debts to employees.  On the balance sheet, liabilities are generally broken down into current liabilities and long-term liabilities.

Current liabilities are those obligations that are usually paid within the year, such as accounts payable, interest on long-term debts, taxes payable, and dividends payable.  Because current liabilities are usually paid with current assets, as an investor it is important to examine to which current assets exceed current liabilities.

The most pervasive item in the current liability section of the balance sheet is accounts payable.  Accounts payable are debts owed to suppliers for the purchase of goods and services on an open account.  Almost all firms buy some or all of their goods on account.  Therefore, you will often see accounts payable on most balance sheets.

Long-term debt is a liability of a period greater than one year.  It usually refers to loans a company takes out.  These debts are often paid in instalments.  If this is the case, the portion to be paid off in the current year is considered a current liability.

That wraps up our short review of liabilities.  You only have one piece left of the balance sheet left to learn – shareholders’ equity.  Remember that assets minus liabilities equal shareholders equity.

406.12           WHAT IS SHAREHOLDERS’ EQUITY?

Shareholders’ equity is the value of a business to its owners after all of its obligations have been met.  This net worth belongs to the owners.  Shareholders’ equity generally reflects the amount of capital the owners invested plus any profits that the company generates that are subsequently reinvested in the company.  This reinvested income is called retained earnings.

Now that we understand the major components, let us move forward to examine a sample balance sheet.

Example of a Balance Sheet

Below you will see an example of a balance sheet and the various components that you have been studying earlier.  The most important lesson to learn in viewing this example is that the basic balance sheet equation holds true.

Assets = Liabilities + Shareholders’ Equity

Pete’s Potato & Pasta, Inc.

Balance Sheet Ending December 31st

                                                                           2004                       2005
ASSETS
Current Assets
Cash and cash equivalents                              $10,000                  $10,000
Accounts receivable                                           35,000                    30,000
Inventory                                                           25,000                    20,000
Total Current Assets                                          70,000                    60,000
Fixed Assets
Plant and machinery                                        $20,000                  $20,000
Less depreciation                                             -12,000                  - 10,000
Land                                                                    8,000                      8,000
Intangible Assets                                                2,000                      1,500
TOTAL ASSETS                                                   88,000                    79,000
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
Accounts payable                                            $20,000                   $15,500
Taxes payable                                                    5,000                        4,000
Long-term bonds issued                                   15,000                     10,000
TOTAL LIABILITIES                                            40,000                      29,500
SHAREHOLDERS’ EQUITY
Common Stock                                                $40,000                     40,000
Retained earnings                                              8,000                     10,000
TOTAL SHAREHOLDERS’ EQUITY                        48,000                     50,000
LIABILITIES & SHAREHOLDERS EQUITY           $88,000                     79,000

 

The key to understanding the balance sheet is in the most basic and fundamental of all accounting equations:  Assets must equal liabilities plus shareholders’ equity.  All further balance sheet analysis will be based upon that building block.

BALANCE SHEET ANALYSIS

We will now look at some of the tools you can use in making an investment decision from balance sheet information. 

406.13           WHY YOU SHOULD ANALYZE A BALANCE SHEET

The analysis of a balance sheet can identify potential liquidity problems.  These may signify the company’s inability to meet financial obligations.  An investor could also spot the degree to which a company is leveraged, or indebted.  An overly leveraged company may have difficulties raising future capital.  Even more severe, they may be headed towards bankruptcy.  These are just a few of the danger signs that can be detected with careful analysis of a balance sheet.

406.14           LIQUIDITY RATIOS

The following liquidity ratios are all designed to measure a company’s ability to cover its short-term obligations.  Companies will generally pay their interest payment and other short-term debts with current assets.  Therefore, it is essential that a firm have an adequate surplus of current assets in order to meet their current liabilities.  If a company has only illiquid assets, it may not be able to make payments on their debts.  To measure a firm’s ability to meet such short-term obligations, various ratios have been developed.

Here are the balance sheet ratios:

  • Current Ratio
  • Acid Test (or Quick Ratio)
  • Working Capital
  • Leverage

These tools will be invaluable in making wise investment decisions.

Current Ratio

The Current Ratio measures a firm’s ability to pay their current obligations.  The greater extent to which current assets exceed current liabilities, the easier a company can meet its short-term obligations.

                                 Current Assets
Current Ratio =  _______________
                              Current Liabilities

After calculating the Current Ratio for a company, you should compare it with other companies in the same industry.  A ratio lower than that of the industry average suggests that the company may have liquidity problems.  However, a

significantly higher ratio may suggest that the company is not efficiently using its funds.  A satisfactory Current Ratio for a company will be with close range of the industry average.

Acid Test or Quick Ratio

The Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except for the fact that it excludes inventory.  For this reason, it’s also a more conservative ratio.

                    Current Assets – Inventory
Acid Test =_____________________
                           Current Liabilities

Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly converted to cash.  If this is the case, inventory should not be included as an asset that can be used to pay off short-term obligations.  Like the Current Ratio, to have an Acid Test Ratio within close range to the industry average is desirable.

Working Capital

Working Capital is simply the amount that current assets exceed current liabilities.  Here it is in the form of an equation.

Working Capital = Current Assets – Current Liabilities

This formula is very similar to the current ratio.  The only difference is that it gives you a dollar amount rather than a ratio.  It too is calculated to determine a firm’s ability to pay its short-term obligations.  Working Capital can be viewed as somewhat of a security blanket.  The greater the amount of Working Capital, the more security an investor can have that they will be able to meet their financial obligations.

You have just learned about liquidity and the ratios used to measure this.  Many times a company does not have enough liquidity.  This is often the cause of being over leveraged.

406.15           LEVERAGE

Leverage is a ratio that measures a company’s capital structure.  In other words, it measures how a company finances their assets.  Do they rely strictly on equity?  Or, do they use a combination of equity and debt?  The answers to these questions are of great importance to investors.

                       Long-term Debt
Leverage = ____________
                        Total Equity

A firm that finances its assets with a high percentage of debt is risking bankruptcy should it be unable to make its debt payments.  This may happen if the economy of the business does not perform as well as expected. A firm with a lower percentage of debt has a bigger safety cushion should times turn bad.

A related side effect of being highly leveraged is the unwillingness of lenders to provide more debt financing.  In this case, a firm that finds itself in a jam may have to issue stock on unfavourable terms.  All in all, being highly leveraged is generally viewed as being disadvantageous due to the increased risk of bankruptcy, higher borrowing costs, and decreased financial flexibility.

On the other hand, using debt financing has advantages.  Stockholder’s potential return on their investment is greater when a firm borrows more.  Borrowing also has some tax advantages.

The optimal capital structure for a company you invest in depends on which type of investor you are.  A bondholder would prefer a company with very little debt financing because of the lower risk inherent in this type of capital structure.  A stockholder would probably opt for a higher percentage of debt than the bondholder in a firm’s capital structure.  Yet, a company that is highly leveraged is also very risky for a stockholder.

When a firm becomes over leveraged, bankruptcy can result.

406.16           BANKRUPTCY

Bankruptcy is a legal mechanism that allows creditors to assume control of a firm when it can no longer meet its financial obligations.  Bankruptcy is a result feared by both stock and bond investors.  Generally, the firm’s assets are liquidated (sold) in order to pay off creditors to the extent that is possible.  When bankruptcy occurs, stockholders of a corporation can only lose the amount they have invested in the bankrupt company.  This is called Limited Liability.  The stockholders’ liability to creditors is limited to the amount invested.  Therefore, if a firm’s liabilities exceed the liquidation value of their assets, creditors also stand to lose money on their investments.

When bankruptcy occurs, a federal court official steps in and handles the payments of assets to creditors.  The remaining funds are always distributed to creditors in a certain pecking order:

  1. Unpaid taxes to the IRS and bankruptcy court fees
  2. Unpaid wages
  3. Secured bondholders
  4. General creditors and unsecured bonds
  5. Subordinated debentures
  6. Preferred Stockholders
  7. Common Stockholders

Obviously, to hold secured bonds rather than unsecured bonds is more advantageous in the event of a bankruptcy.  This is where you must examine your risk/reward requirements.  As you move down this hierarchy, your risk of losing your investment increases.  However, you are “rewarded” for taking more risk with potentially higher investment returns.

How do you predict bankruptcy?  Well, no one can do it perfectly.  However, one popular method called a Z-score (developed by Edward Altman) has a good track record.  To learn more about “Z-scores” go to your local library.  We will recap a few of the most important points about learning to analyze a company’s balance sheet.

406.17           TYING IT ALL TOGETHER

Analyzing a balance sheet is fundamental knowledge for anyone who wishes to carefully select solid and profitable investments.  The balance sheet is the basic report of a firm’s possessions, debts and capital.  The composition of these three items will vary dramatically from firm to firm.  As an investor, you need to know how to examine and compare balance sheets of different companies in order to select the investment that meets your needs.

UNDERSTANDING INCOME STATEMENTS

A company’s income statement is a record of its earnings or losses for a given period.  It shows all of the money a company earned (revenues) and all of the money a company spent (expenses) during this period.  It also accounts for the effects of some basic accounting principles such as depreciation.

The income statement is important because it’s the basic measuring stick of profitability.  A company with little or no income has little or no money to pass on to its investors in the form of dividends.  If a company continues to record losses for a sustained period, it could go bankrupt.  In such a case, both bond and stock investors could lose some or all of their investment.  On the other hand, a company that realizes large profits will have more money to pass on to its investors.

Here is an Example of a basic Income Statement

The income statement shows revenues and expenditures for a specific period, usually the fiscal year.  Income statements differ by how much information they provide and the style in which they provide the information.  Here is an example of a hypothetical income statement, with the revenues in black and expenditures in red (and parentheses):

Wilma’s Widgets Income Statements

for the Years Ending 2004 and 2005

                                                                                  2004                       2005
Sales                                                                     $900,000                $990,000
Less Cost of Goods Sold                                        (250.000)               (262,500)
Gross Profit on Sales                                               650,000                 727,600
Less General Operating Expenses                         (120,000)              (127,500)
Less Depreciation Expense                                      (30,000)                (30,000)
Operating Income                                                   500,000                 570,000
Other Income                                                            50,000                   30,000
Earnings Before interest and Tax                           550,000                  600,000
Less Interest Expense                                            (30,000)                 (30,000)
Less Taxes                                                              (50,000)                 (54,500)
Net Earnings (Available Earnings                           470,000                  515,500
                      For Dividends)
Less Preferred and/or Common Dividends Paid     (70,000)                 (80,000)
Retained Earnings                                                 400,000                 435,500

Now, as perplexing as those numbers might seem at first, you will become comfortable with them very quickly once we explain what all this financial jargon really means.  Let us start by looking at the first term that was calculated – gross profit on sales.

406.18           GROSS PROFIT ON SALES

Gross profit on sales (also called gross margin) is the difference between all the revenue the company earns and the sales of its products minus the cost of what it took to produce them.  Let us move on to clarify how to calculate this important number.

Gross Profit on Sales = Net Sales – Cost of Goods Sold

Simple, yes, but let’s be sure we know that the terms sales and cost of goods sold means to the accountants.

Net sales are the total revenue generated from the sale of all the company’s products or services minus an allowance for returns, rebates, etc.  Sometimes on an income statement, you might see terms “gross sales” and “returns”, “rebates” or “allowances”.  Gross sales are the total revenue generated from the company’s products or services before returns or rebates are deducted.  Net sales on the other hand have all these expenses deducted.

Cost of goods sold is what the company spent to make the things if sold.  Cost of goods sold includes the money the company spent to buy the raw materials needed to produce its products, the money it spent on manufacturing its products and labor costs.

When yo9u subtract all the money a company spent in the production of its goods and services (cost of goods sold) from the money made from selling them (net sales), you have calculated their gross profit on sales.

Gross profit on sales is important because it reveals the profitability of a company’s core business.  A company with a high gross profit has more money left over to pump into research and development of new products, a big marketing campaign, or better yet – to pass on to its investors.  Investors should also monitor changes in gross profit percentages.  These changes often indicate the causes of decreases or increases in a company’s profitability.  For instance, a decrease in gross profit could be caused by an industry price war that has forced the company to sell its products at a lower price.  Poor management of costs could also lead to a decreased gross profit.

406.19                       OPERATING INCOME

Operating income is a company’s earnings from its core operations after it has deducted its cost of goods sold and its general operating expenses.  Operating income does not include interest expenses or other financing costs.  Nor does it include income generated outside the normal activities of the company, such as income on investments or foreign currency gains.

Operating income is particularly important because it is a measure of profitability based on a company’s operations. In other words, it assesses whether or not the foundation of accompany is profitable.  It ignores income or losses outside of a company’s normal domain.  It also excludes extraordinary events, such as lawsuits or natural disasters, which in a typical year would not affect the company’s bottom line.

An easy way to calculate operating income is as follows:

Operating Income = Gross profit – General Operating Expenses – Depreciation Expense

General operating expenses are normal expenses incurred in the day-to-day operation of running a business. Typical items in this category include sales or marketing expenses, salaries, rent, and research and development costs.

Depreciation is the gradual loss in value of equipment and other tangible assets over the course of its useful life.  Accountants use depreciation to allocate the initial purchase price of a long-term asset to all of the periods for which the asset will be used.

406.20                       EARNINGS BEFORE INTEREST AND TAXES

Earnings before interest and taxes (EBIT) are the sum of operating and non-operating income.  This is typically referred to as “other income” and “extraordinary income” (or loss).  As its name indicates, it is a firm’s income excluding interest expenses and income tax expenses.  EBIT is calculated as follows:

EBIT = Operating Income =- (-) Other Income (Loss) + (-) Extraordinary Income (Loss)

Since we already know what operating income is, let’s take a closer look at what other income and extraordinary income mean.

Other income generally refers to income generated outside the normal scope of a company’s typical operations.  It includes ancillary activities such as renting an idle facility or foreign currency gains.  This income may happen on an annual basis, but is it considered unrelated to the company’s typical operations.

Extraordinary income (or loss) occurs when money is gained (or lost) resulting from an event that is deemed both unusual and infrequent in nature.  Examples of such extraordinary happenings could include damages from a natural disaster or the early repayment of debt.

Many companies may not have either other income or extraordinary income in a given year.  If this is the case, then earnings before income and taxes is the same as operating income.  Regardless of how it is calculated, EBIT is especially relevant to bondholders and other debtors who use this figure to calculate a firm’s ability to “cover” or pay its interest payments with its income for the year.

406.21                       NET EARNINGS (OR LOSS)

Net earnings or net income is the proverbial bottom line.  It measures the amount of profit a company makes after all of its income and all of its expenses.  It also represents the total dollar figure that may be distributed to its shareholders.  Net earnings are also the typical benchmark of success.  Just a reminder, however, many companies report net losses rather than net earnings.

How do we calculate net earnings?

Net Earnings = Earnings Before Interest and Taxes – Interest Expenses – Income Taxes

Interest expense refers to the amount of interest a company has paid to its debtors in the current yea.  Meanwhile, income taxes are federal and state taxes based upon the amount of income a company generates.  Often a company will defer its taxes and pay them in later years.

Net earnings are particularly important to equity investors because it is the money that is left over after all other expenses and obligations have been paid.  It is the key determinant of what funds are available to be distributed to shareholders or invested back in the company to promote growth.

406.22                       RETAINED EARNINGS

Retained earnings are the amount of money that as company keeps for future use or investment.  Another way to look at it is as the earnings left over after dividends are paid out.  Generally, a company has a set policy regarding the amount of dividends it will pay out every year.  In this case, 70% of net earnings become retained earnings.

Calculation of retained earnings:

Retained Earnings = Net Earnings – Dividends

To better understand retained earnings, we need to explain the nature of dividends.  Dividends are cash payments made to the owners or stockholders of the company.  A profitable year allows them to make such payments, although there generally are no obligations to make such payments.  When a company has both common and preferred stockholders, the company has two different types of dividends to pay.

Every publicly traded company has common stockholders.  Dividend payments to common stockholders are optional and up to each company to decide how (or if) it will make such payments.  A firm may decide to place all of its earnings into new investments to promote future growth.  Preferred stockholders are in line before common stockholders if a dividend is declared.  However, not all companies have preferred stockholders.

It is important to know what a company does with its net earnings.  An investor needs to know the company’s dividend and retained earnings policies to decide whether the company’s objectives are in line with the investor’s.  If the company pays dividends it is income-oriented.  If it retains earnings for future expansion, it is growth-oriented.

Knowing the source of income and expenses is necessary when reading an income statement.  Two helpful mnemonic devices have been created out of the major components of the income statement.

406.23           INCOME STATEMENT MNEMONICS

Although these mnemonics may not account for every line on an income statement, these two will help you remember the major parts, and the order in which they appear.  The word “SONAR” identifies the major sales and earnings.  The word “EDIT” summarizes major expenditures.

S = Sales (gross)

         E=Less expenses (general operating expenses and cost of goods sold)

         D=Less depreciation

O=Operating income (before interest and taxes)

         I=Less interest

         T=Less taxes

N=Net earnings

A=Available earnings for common stock

R=Retained earnings

Let’s conclude with a review of the importance of the income statement for investors.  The income statement provides the investor with much insight to the company’s revenues and expenses.  You can identify where the company spends much of its income and compare that to similar companies.  You can also compare a company’s performance with previous years.  Most importantly, the income statement tells if the business is profitable.  If the company continually makes substantial profits, it indicates to bondholders that it is a stable company.

 

INCOME STATEMENT ANALYSIS

The income statement is a basic record for reporting a company’s earnings.  Since earnings are a fundamental component in a firm’s worth, it is essential to know how to analyze different elements of this important document.

By analyzing an income statement properly, you can begin to evaluate the effectiveness of the management of operations in the companies in which you are interested in.

406.24                       INTEREST COVERAGE (a.k.a. TIMES INTEREST EARNED)

Interest Coverage is the measurement of how many times interest payments could be made with a firm’s earnings before interest expenses and taxes are paid.  From a bondholder’s perspective, interest coverage is a test to see whether a firm could have problems making their interest payments.  From an equity holder’s perspective, this ration helps to give some indication of the short-term financial health of the company.

The following formula is used to determine the coverage of interest:

                                       Earnings Before Interest and Taxes (EBIT)
Interest Coverage Ratio = __________________________________
                                                     Interest Expense

A higher ratio is typically better for bondholders and equity investors.  For bondholders a high ratio indicates a low probability that the firm will go bankrupt in the near term.  A company with a high interest coverage ratio can meet their interest obligations several times over.  Stock investors typically like companies with high interest coverage ratios too.  A high ratio indicates a company that is probably relatively solvent.  Thus, all other things equal, an investor should be very careful with firms that have a low interest Coverage Ratio with respect to other companies in their industry.

Since the fundamental purpose of the income statement is to report profits or losses, understanding the various profitability ratios that follow are extremely helpful to your analysis of a firm.

406.25           PROFITABILITY RATIOS

Profitability is often measured in percentage terms in order to facilitate making comparisons of a company’s financial performance against past year’s performance and against the performance of other companies.

When profitability is expressed as a percentage (or ratio), the new figures are called profit margins.  The most common profit margins are all expressed as percentages of Net Sales.

Let’s look at a few of the most commonly used profit margins that you can easily learn to use to help you measure and compare firms:

Gross Margin is the resulting percentage when Gross Profit is divided by Net Sales.  Remember that Gross Profit is equal to Net Sales – Cost of Goods Sold.  Therefore, Gross Margin represents the percentage of revenue remaining after Cost of Goods Sold is deducted.  Let us take a look at a simple example.

Net Sales =              $1,000
Cost of Goods Sold = 400
                             ______
Gross Profit =           $  600

                     

                            Gross Profit
Gross Margin = _________
                              Net Sales

In this example the Gross Margin = 600/1000 = .60 or 60%

Since this ratio only takes into account sales and variable costs (costs of goods sold), this ratio is a good indicator of a firm’s efficiency in producing and distributing its products.  A firm with a ratio superior to the industry average demonstrates superior efficiency in its production processes.  The higher the ratio, the higher the efficiency of the production process.  Investors tend to favour companies that are more efficient.

Operating Margin.  As the name implies, operating margin is the resulting ratio when Operating income is divided by Net Sales.

                                    Operating Income
Operating Margin = ______________
                                            Net Sales

This ratio measures the quality of a firm’s operations.  A firm with a high operating margin in relation to the industry average has operations that are more efficient.  Typically, to achieve this result, the company must have lower fixed costs, a better gross margin, or a combination of the two.  At any rate, companies that are more efficient than their competitors in their core operations have a distinct advantage.  Efficiency is good.  Advantages are even better. 

Let’s move on to the last profitability measure we will cover in this section.

Net Margin.  As the name implies, Net Margin is a measure of profitability for the sum of a firm’s operations.  It is equal to Net Profit divided by Net Sales.

                    Net Profit
Net Margin = _________
                    Net Sales

As with the other ratios you will want to compare Net margin with other companies in the industry.  You can also track year-to-year changes in net margin to see if a company’s competitive position is improving, or getting worse.

The higher the net margin relative to the industry (or relative to past years), the better.  Often a high net margin indicates that the company you are looking at is an efficient producer in a dominant position within its industry.  However, as with all the previous profit margin measurements, you need to always check past years of performance.  You want to make sure that good results are not a “fluke”.  Strong profit margins that are sustainable indicate that a company has been able to consistently outperform their competitors.

The savvy investor uses profitability margins to help analyze income statements of prospective company purchases or investments.  Companies with high interest coverage ratios, gross margins, operating margins and net margins will always be very attractive to investors.

406.026         WHERE DID ALL THOSE EXPENSES COME FROM?

You have just finished learning about interest coverage and profitability ratios.  Both of these measures are simple and easy to understand.  Interest coverage measures a company’s ability to make its loan payments.  Profitability ratios measure the bottom line of the income statement – earnings.

However, to calculate either ratio, you must be able to classify a company’s expenses.  The interest coverage ratio concerns itself with a specific type of expense (interest expense).  Meanwhile, profitability ratios such as net profit margin consider the net effect of all the expenses a company incurs.

Most of the expenses a company may incur (raw materials, labor, rent, etc.) are straightforward items.  In general, companies want to minimize these sorts of expenditures to ensure improved performance and profitability.  For example, the less a company has to pay for the raw materials of the products it produces, the more competitive that company can become.

Yet, there is one type of expense companies cannot eliminate.  In fact, incurring this expense actually helps save the company money.  What is this mysterious expense?

Depreciation Expense

Depreciation is the process by which a company gradually records the loss in value of a fixed asset.  The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life.

Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased.  However, unlike other expenses, depreciation expense is a “non-cash” charge.  This simply means that no money is actually paid at the time in which the expense is incurred.

Like all other expenses, depreciation expense reduces the taxable income of the company.  Yet, a business reporting a depreciation expense incurs no additional cash expenditure.  Simply put, depreciation allows businesses to reduce their taxable income without making the additional cash expenditure typical of most other expenses.

While depreciation is an attractive way to reduce taxable income, specific regulations govern how it is to be calculated and allocated.  Let’s take a moment to review a few important points about how companies calculate depreciation.

406.27                       BASIC POINTS ABOUT CALCULATING DEPRECIATION

When analyzing income statements, it is very important to understand how different accounting methods for calculating depreciation affect the income statement.  Sometimes the accounting methods selected can materially alter the result of this important statement.

Most businesses have the right to choose amongst a number of different depreciation schedules.  Typically, businesses elect a depreciation schedule to suit their specific needs or preferences.  In order to make comparisons of different companies, you will need to know the role that accounting plays in the final composition of their respective income statements.

Straight-Line Depreciation

Straight-line Depreciation is the simplest and most commonly used accounting method for depreciation.  Basically, the straight-line depreciation method calculates the amount of annual depreciation expense that is to be recorded by dividing the value of the asset (as determined by its purchased price) by its useful life.  Often some adjustment is made for the anticipated “residual value” that the asset may have at the end of its “useful life”.

The Tax Service provides taxpayers with a depreciation schedule that defines what the useful life of different types of assets (cards, computers, etc) is to be.  Thus, an item that has a relatively short-lived useful life (such as a computer) may be able to be depreciated more quickly than an asset (such as a building) that has a long and useful life expectancy ahead of it.

Using a straight-line depreciation schedule, businesses deduct the same amount of depreciation each year until the assets have been fully depreciated.

Accelerated Depreciation Methods

Accelerated Depreciation Methods are also a very common way for companies to allocate their depreciation expenses.  These methods are those methods that are utilized to write off depreciation costs more rapidly than the straight-line method.

Various accelerated methods exist.  Two popular methods of accelerated depreciation are Sun-of-the-Years’-Digits and Double Declining Balance.  These methods are more complex in nature and we will not delve into their calculations at present.

However, the important thing to know is that each of these methods record depreciation expense more heavily in the current years in comparison to the straight-line method.  By recording more expense in the early stages of an assets useful life, accelerated depreciation methods reduce the taxable income for those years.  However, in later years, accelerated depreciation methods will record less depreciation, leaving more income.  The company will therefore have to pay greater taxes.

Selecting a Depreciation Method

For the company, the choice of depreciation method will depend on a company’s current financial situation and/or its own preferences.  Companies that wish to defer current taxable income may elect accelerated depreciation methods to accomplish this goal.  However, companies that need to show large earnings in the current year may elect to forgo accelerated depreciation methods and opt for a straight-line method.  Both methods have their advantages and disadvantages.  Typically, a company is free to choose the method that best suits its preferences.

However, as a buyer/investor, you will likely not have the power to tell the company what method to use.  Instead you will need to know how each of these different methods can alter an income statement.  If you can do this, you will be able to evaluate how a company’s depreciation schedule impacts the value of the investment opportunity.

When making comparisons of different companies, you should always check to see if they use the same accounting methods. If not, you will want to make an adjustment in order to effectively compare these companies.

At first, comparing depreciation methods and accounting rules may seem daunting.  However, with a little practice you will be armed and ready to really understand the companies you are interested in.

Using the analysis techniques that we have introduced, you have a good basis of knowledge from which to make informed decisions.  Remember that the main purpose of the income statement is to report profitability.

For more information on:

Calculating Profitability Ratios

And, How Analysts Present Their Findings

Go to Suite 506:  Valuation Principles

HOW ANALYSTS PRESENT THEIR FINDINGS

AID TO BUSINESS
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GOING INTO BUSINESS?
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