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Five Tips for Analyzing an Income Statement
In this article, we'll be looking at the income statement, which is the most deceptively simple of the major financial statements. I say simple because it's just a list of all the revenue, minus all the expenses, to calculate what's left over in profit. It's no more difficult than putting your family budget together, right?
That's where the deceptive part of the description comes in. The items on the income statement are easily manipulated by, say, less-than-honest management, and don't necessarily represent the true situation at a company. Even totally honest companies can have income statements that don't represent economic reality. Cash flows define economic reality, revenue and expenses define accounting reality.
You see, the difference between your household budget and a company's income statement is their relationships to actual cash flows. Your household budget will generally match your cash inflows and outflows. Not so with an income statement. Income statements can vary significantly from the company's cash flow, meaning that a company in economic trouble can show a very "good" income statement up until the day it goes bankrupt.
Generally speaking, though, the income statement is a good place to start when evaluating a company. In my forthcoming e-book, Fundamentals of Financial Statement Analysis, I lay out the process for evaluating the health of a company through the financial statements. Here are some tips and strategies for evaluating an income statement.
1. Create a Common Size Statement
What's a common size statement, you ask? It's the income statement, only with each line item represented as a percentage of sales. This is easy to do with a spreadsheet on your computer, but you can do it on paper just as well. Net Sales is always 100% at the top, and each of the expenses is divided by total sales to arrive at a percentage. For example, if a company has $100 in sales and $50 in cost of goods sold, the
In this article, we'll be looking at the income statement, which is the most deceptively simple of the major financial statements. I say simple because it's just a list of all the revenue, minus all the expenses, to calculate what's left over in profit. It's no more difficult than putting your family budget together, right?
That's where the deceptive part of the description comes in. The items on the income statement are easily manipulated by, say, less-than-honest management, and don't necessarily represent the true situation at a company. Even totally honest companies can have income statements that don't represent economic reality. Cash flows define economic reality, revenue and expenses define accounting reality.
You see, the difference between your household budget and a company's income statement is their relationships to actual cash flows. Your household budget will generally match your cash inflows and outflows. Not so with an income statement. Income statements can vary significantly from the company's cash flow, meaning that a company in economic trouble can show a very "good" income statement up until the day it goes bankrupt.
Generally speaking, though, the income statement is a good place to start when evaluating a company. In my forthcoming e-book, Fundamentals of Financial Statement Analysis, I lay out the process for evaluating the health of a company through the financial statements. Here are some tips and strategies for evaluating an income statement.
1. Create a Common Size Statement
What's a common size statement, you ask? It's the income statement, only with each line item represented as a percentage of sales. This is easy to do with a spreadsheet on your computer, but you can do it on paper just as well. Net Sales is always 100% at the top, and each of the expenses is divided by total sales to arrive at a percentage. For example, if a company has $100 in sales and $50 in cost of goods sold, the