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Financial statement analysis a look at the income sheet
Natural Language University (FCIHcs462)
Helwan University
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The income statement reports on one of the most critical company figures— its earnings per share. O ver the long run, a stock’s value is dependent upon its earnings potential. Investors closely monitor earnings announcements. Stock price can nose dive when earnings expectations are missed by even a few pennies. Therfore, it is important to be able to read and understand an income statement and identify trends of key items that impact earnings. This fundamentals article is the second in a series on financial statements— how to read them and use them for stock analysis. The balance sheet was introduced in the January 1999 A A II Journal. This fundamentals article will examine the income statement. Every other issue of the A A II Journal this year will carry an article explor- ing the use and interpretation of financial statements. We are collecting and organizing these articles under the heading “ Focus on Financial Statements” within the stocks area on our Web site (aaii/stocks/). We are also publishing member questions and answers related to financial statements. If you have any questions or comments, please E-mail them to financials@aaii.
THE IN COM E STATEM EN T
The goal of the income statement is to determine revenue for the period that it covers and then match the corresponding expenses to the revenue. The income statement, sometimes referred to as the statement of earnings or statement of operations, presents a picture of a company’s profitability over the entire period of time covered. This is in contrast to the balance sheet, which presents a snapshot of a company’s financial condition at a specific point in time. The income statement cumulates revenues and expenses and presents the results in a statement that is designed to be read from top to bottom. Like the balance sheet, the income statement reflects management’s decisions, esti- mates, and accounting choices. Just looking at the bottom-line profits may mislead investors. A careful, step-by-step review of the income statement is useful in order to judge the quality and content of the bottom-line earnings figure. The income statement outline presented in Table 1 has five income steps: (1) gross income, (2) operating income, (3) income before taxes, (4) income after taxes and (5) net income. There is a wide latitude of income statement formats used by firms, but the five-step format is useful in explaining the information provided by the statement.
ACCRUAL ACCOUN TIN G
Before the income statement can be analyzed correctly, it is important to understand that most companies report their financials using the accrual principle of accounting. Sales revenues and expenses are recorded when they are earned and incurred whether or not cash has been received or paid. Sales should only be recorded once the exchange of goods or services has been
By John Bajkowski
The goal of the
income statement is
to determine revenue
for the period
covered and then
match the
corresponding
expenses to the
revenue. It presents a
picture of a
company’s
profitability over the
entire period of time
covered.
Jo hn Bajko wski is AAII’s se nio r financial analyst and e dito r o f Co mpute rize d Inve sting.
FIN AN CIAL STATEM EN T AN ALYSIS:
A LOOK AT THE IN COM E SHEET
of sale. Companies are required to estimate an allowance for future returns on sales made during the reporting period. M ost companies report net sales within the income statement, which is sales less this allowance and other sales discounts. The notes to the financial statements would typically have to be studied to see the estimated annual allowance. Accounts receivable, a balance sheet item, should roughly move in tandem with sales. Accounts receiv- able is the credit extended to cus- tomers to purchase goods. Accounts receivable increasing at a faster rate than sales may point to more lenient change in a firm’s credit policy toward customers, or a firm pushing unwanted products out to customers to boost short-term sales. The quarter-end period is a noteworthy time for companies to push this sales recognition frontier. Some firms have gone so far as to send unfin- ished, returned, and defective goods just to meet a sales growth objective. While outright fraud is difficult for an outsider to detect, a sudden increase in accounts receivable relative to sales is a warning flag that merits further investigation. N ot all cash received in connection with a sale can be booked as sales for a given reporting period. Firms must match up the sales revenue to the period in which the good or service is delivered. A magazine publisher that receives cash for a multi-year subscription should only count that portion of the subscrip- tion delivered during the current reporting period as sales, and establish a balance sheet liability titled unearned revenue for the remainder of the subscription. In subsequent periods, the appropriate portion of unearned revenue account can be converted into sales. Trends in sales are extremely important in judging the current health and prospects of the firm.
COST OF GOODS SOLD
The cost of goods sold item
TABLE 1. IN COM E STATEM EN T STRUCTURE completed and the sale has been completed. Expenses are recorded when the goods and services that generate expenses are used. Accrual accounting includes credit sales in the sales line and records them as accounts receivable on the asset side of the balance sheet. Like- wise, unpaid (accrued) expenses are presented as expenses on the income statement, but recorded as liabilities on the balance sheet. The cash flow statement, which will be covered in the June 1999 A A II Journal , looks directly at generation and use of cash within the com- pany.
SALES
Sales revenue is the total of sales for the period. Sales should not be booked unless there is a high prob- ability that the goods will not be returned and the customer will pay for them. Risk and benefit of ownership of the goods should have been transferred to the buyer in order to be considered a finished sale. For example, it is common for publishers to sell books to book- stores under the provision that the bookstore may return unsold books. Under this circumstance it would not be proper to record all of the revenue from this type
Net Sales RevenueNet Sales RevenueNet Sales RevenueNet Sales RevenueNet Sales Revenue..........................................................................................................................................................................................................................................................$8,
Less Cost of Goods SoldLess Cost of Goods SoldLess Cost of Goods SoldLess Cost of Goods SoldLess Cost of Goods Sold.................................................................................................................................................................................................................,
Gross Incom eGross Incom eGross Incom eGross Incom eGross Incom e......................................................................................................................................................................................................................................................................................................,
Operating ExpensesOperating ExpensesOperating ExpensesOperating ExpensesOperating Expenses
Selling, Adm inistrative and General..................., Research and Developm ent...................................... 450 Depreciation.................................................................. 80 Am ortization of Intangibles ........................................ 20 Total Operating ExpensesTotal Operating ExpensesTotal Operating ExpensesTotal Operating ExpensesTotal Operating Expenses...............................................................................................................................................................,
Operating Incom eOperating Incom eOperating Incom eOperating Incom eOperating Incom e........................................................................................................................................................................................................................................................................................ 750
Other Incom e (Expense)Other Incom e (Expense)Other Incom e (Expense)Other Incom e (Expense)Other Incom e (Expense) Interest Incom e (Expense).....................................(120) Non-Operating Incom e (Expense)............................. 50 Gain (Loss) on Sale of Assets..................................(10) Total Other Incom e (Expense).................................(80)
Incom e Before TaxesIncom e Before TaxesIncom e Before TaxesIncom e Before TaxesIncom e Before Taxes............................................................................................................................................................................................................................................................... 670
Incom e TaxesIncom e TaxesIncom e TaxesIncom e TaxesIncom e Taxes.............................................................. 240........................................................................................................................................................................................................................................................
Incom e After TaxesIncom e After TaxesIncom e After TaxesIncom e After TaxesIncom e After Taxes...................................................... 430........................................................................................................................................................................................................................
Extraordinary Gain (Loss)Extraordinary Gain (Loss)Extraordinary Gain (Loss)Extraordinary Gain (Loss)Extraordinary Gain (Loss)...................................................................................................................................................................................................................................... 15 Gain (Loss) on Discontinued OperationsGain (Loss) on Discontinued OperationsGain (Loss) on Discontinued OperationsGain (Loss) on Discontinued OperationsGain (Loss) on Discontinued Operations.........................................................................................................(60) Cum ulative Effect of Change in AccountingCum ulative Effect of Change in AccouCum ulative Effect of Change in AccountingCum ulative Effect of Change in AccouCum ulative Effect of Change in Accountingntingnting.......................................................................................... (5)
Net Incom eNet Incom eNet Incom eNet Incom eNet Incom e.................................................................. 380........................................................................................................................................................................................................................................................................
Less Preferred DividendsLess Preferred DividendsLess Preferred DividendsLess Preferred DividendsLess Preferred Dividends........................................................................................................................................................................................................................................... 10
Net Earnings Available for Com m onNet Earnings Available for Com m onNet Earnings Available for Com m onNet Earnings Available for Com m onNet Earnings Available for Com m on....................................................................................................................................... 370
Com m on DividendsCom m on DividendsCom m on DividendsCom m on DividendsCom m on Dividends......................................................................................................................................................................................................................................................................... 100
Earnings Per Share–BasicEarnings Per Share–BasicEarnings Per Share–BasicEarnings Per Share–BasicEarnings Per Share–Basic....................................................................................................................................................................................................................... Earnings Per Share–DilutedEarnings Per Share–DilutedEarnings Per Share–DilutedEarnings Per Share–DilutedEarnings Per Share–Diluted........................................................................................................................................................................................................
Dividends per ShareDividends per ShareDividends per ShareDividends per ShareDividends per Share...............................................................................................................................................................................................................................................................
Consolidated Statem ent of Retained EarningsConsolidated Statem ent of Retained EarningsConsolidated Statem ent of Retained EarConsolidated Statem ent of Retained EarningsConsolidated Statem ent of Retained Earningsnings
Balance, Beginning of YearBalance, Beginning of YearBalance, Beginning of YearBalance, Beginning of YearBalance, Beginning of Year............................................ 30................................................................................................................................................................................ Net Incom e.................................................................. 370 Cash Dividend Declared on Com m on.................(100) Retained Earnings Balance, End of YearRetained Earnings Balance, End of YearRetained Earnings Balance, End of YearRetained Earnings Balance, End of YearRetained Earnings Balance, End of Year...................... 300........................................................................................
tion of tax liabilities between the accounting statements prepared for the IRS and those presented to investors. For example, a firm may use an accelerated depreciation schedule when reporting income to the IRS, but a straight-line method for reporting income to investors. Since more depreciation and lower income would be recorded in the early years of the asset for tax purposes, the tax liability would be smaller for the IRS-prepared state- ments. The difference would be considered deferred income taxes and would show up as a liability on the balance sheet. This temporary difference would reverse itself in the later years of the asset life when the annual straight-line depreciation amounts exceed the annual acceler- ated depreciation expense.
ADJUSTM EN TS TO IN COM E
Subtracting income tax expense from income before taxes produces aftertax income. For most firms this figure will also be the net income, however there are three notable items that may be listed after taxes—extraordinary items, discon- tinued operations, and cumulative effect of change in accounting. Extraordinary items are distin- guished by their unusual nature and by the infrequency of their occur- rence. An uninsured loss from an earthquake would qualify as an extraordinary item. The event should not be related to the firm’s normal course of business. The discontinued operations line can detail the gain or loss from the disposing a segment of a firm’s business or closing down a line of business. As companies adapt new account- ing policies or make corrections to past financial statements, there may
be the need take a special one-time, non-cash charge. This charge would be reflected in the line item “ cumula- tive effect of change in accounting” and described in the footnotes. Investors need to be aware of management’s propensity to deter- mine these types of adjustments. M anagement has control over factors such as the timing of selling a business or closing down a line. Some firms have shown a tendency to bunch up adjustments to clear the slate for future profits. When earnings are expected to be weak during a particular period, there may be a push to take a “ big bath.” When new management takes over a company, there is also a strong temptation to write-off old projects and assets to show strong improve- ments during future periods. Recently the Securities and Ex- change Commission warned compa- nies reporting charges that it will examine the charges closely and reiterated the disclosure require- ments for justifying and explaining the determination of each charge.
N ET IN COM E
N et income or earnings is the bottom line figure that attracts the most attention. Usually, however, it is reported in a different format, as earnings per share. The earnings per share figure (basic earnings per share) is simply the net income of the firm, less any preferred dividend payments, divided by the average number of common shares outstand- ing during the period. If a company had convertible bonds or stocks, stock options, and warrants, it must also calculate a diluted earnings per share, which measures the impact on earnings per share created by the conversion and exercising of all of these securities into common stock.
Both the basic and fully diluted earnings per share must be reported in the income statement. The same line item may be labeled basic and diluted if the company has no convertible securities. The notes to financial statements should include a table describing the calculation of basic and diluted earnings per share. The statement of retained earnings section details how the retained earnings figure on the balance sheet is affected by the current period earnings and dividend decisions. The retained earnings are not necessarily available cash, but instead may be invested in other current and long- term assets of the firm.
CON CLUSION
The income statement provides insights on how well management can translate sales revenues into earnings. There are many manage- ment judgments, estimates, and choice of accounting methods that affect the bottom line, so it is important to be aware and alert to these issues when judging the quality of the firm’s earnings. N o single year will capture the dynamics of the firm. A careful comparison of changes and an identification of trends can aid in judging the attractiveness of the stock. The income statement pro- vides valuable guidance on the sales and earnings trend of a firm. But it does a poor job of identifying whether the company is producing cash flow. In our next article, we will go directly to the source and examine the cash flow statement. If you have any questions regard- ing the income statement, please E- mail them to financials@aaii. In M ay we will post weekly questions and answers on our Web site at aaii.✦✦✦✦✦
Financial statement analysis a look at the income sheet
Course: Natural Language University (FCIHcs462)
University: Helwan University
