Evaluating Financial Statements – The Income Report

 

The first step in finding potential investment opportunities is to be able to go through and evaluate a company’s financial report. In this article we evaluate the Income Report and show how investors can use the information within the income report to uncover potential value.

In addition to the Income Report, companies also release a Balance Sheet (discussed in detail here) and a Statement of Cash Flows which we cover in detail in other articles.

 

Before you begin investing in individual companies you must have a basic understanding of what these 3 financial statements tell you. There is no better way to truly assess a company’s standing than taking the time to read these reports.

 

Sometimes this is no easy task. Annual reports (10k reports) may be hundreds of pages long, filled with complicated financial lingo and lots of confusing numbers. Quarterly financial statements (10q reports) are often 50+ pages long and contain similar obstacles.

 

In this article we will go through several examples of evaluating a company’s income statement and help you determine what information is significant and what conclusions you can draw based on the given information. By being able to comb through these documents, you will know information that only a small percentage of investors know. Simply put, many investors are lazy and purchase stocks based on TV news coverage or co-worker tips. Very few buy a stock based on research of a company’s financial statements as evidenced by the significant under performance the average individual investor achieves compared to the market.

 

 

The SEC (Security Exchange Commission) mandates that any publicly traded company listed on an exchange must release both quarterly financial reports, also know as a “10-Q” and annual financial reports, known as a “10-K”.

 

Let’s start with an example company. For this article we will look at Praxair, Inc. Ticker Symbol PX – A company that sells atmospheric gases such as helium and oxygen – and one of the most widely held stocks in the world.

(Incase you are wondering – I have no direct investments in Praxair)

 

 

Basic information can be found on Praxair on financial websites such as Yahoo Finance, and is shown below. (Praxair’s yahoo finance page is here)

 


 

How many investors buy a stock based on this information, or less? This information tells us very little about the fundamental health of the business.

 

To truly understand how the business is doing, we need to dig a little deeper – into the company’s financial statements.

 

The SEC (Securities and Exchange Commission) has every publicly traded company financial statements in an online database, called the EDGAR system. Investors can search for the financial statements of any company on EDGAR’s search page, found here:

 

From the SEC’s EDGAR database, start by searching by ticker symbol PX

 

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From this search you will see a long list containing every filing Praxair has submitted to the SEC. Lets look for the most recent 10-K, or annual report.

 

For those reading this article in the future – we are bringing up 2011’s 10-K.

 

 

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There are several ways to bring up the report.

 

The blue ‘Interactive Data’ button brings you to a page where you can view the income statement, along with the balance sheet and statement of cash flows, by selecting the appropriate box on the left side of the page. From here you can also download the data into Excel (circled in green in the picture below). Downloading data to Excel is my preferred way to view the data within the reports.

 

 

 

Or instead of clicking the blue “Interactive Data” button, you can click the white “Documents” button to the left and download the filing in PDF format. Click the .htm link circled in green below to open up the 107 page document. These 107 pages contain much more than just the Income Report. Over time BegintoInvest.com will have articles covering everything within this document. For this article – all we are concerned with is the sections dealing with the company’s Income Report.

 

 

 

Getting into the Report

 

Now that we have the report up – let’s run down the terms that make up a company’s Income Report and discuss why they are important.

 

Praxair’s Income Statement is located on page 49 of the company’s 2011 10k report.

 

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Let’s quickly discuss the terms on Praxair’s Income Statement and common on other company’s Income Statements:

 

Sales – (Also known as Revenue) represent the total value of products sold by the company during the last year (or quarter if viewing a 10q report). Note, this is not the company’s profit. Sales are the money the company receives for its products but do not reflect the cost to produce that item or any other expenses of the company.

 

If you buy a bottle of Coca-Cola for $1, that $1 is reported by Coca-Cola as $1 in Sales, however that is not a $1 profit for Coca-Cola because it does not factor in the costs to produce that bottle of Coca-Cola.

 

The Sales number is commonly referred to as the “Top line number”. It is the money the company starts with before costs and expenses are taken into account.

 

Cost of sales – Cost of sales represents the money the company has to spend to produce the items it sells. This includes cost of raw materials and employee labor costs used to produce a product. It is one of the numbers subtracted from Sales to determine a company’s  profit.

 

 

Depreciation and Amortization – Often used interchangeably, both Amortization and Depreciation reflect charges on the Income Statement due to reduction in book value of an asset on the balance sheet. Generally Amortization reflects the change in an intangible asset’s value over time, while Depreciation reflects the change in a tangible assets value over time.

 

Consider a company that pays $1 million in order to develop a patent (which is an intangible asset) which has a life of 10 years. In order to spread the costs out and pay for the $1 million over time, the company will charge $100,000 ($1 million divided by 10 years, or $100,000) per year under Amortization. This means the value of the company’s intangible assets on its balance sheet will also drop by $100,000 per year.

 

For tangible assets this reduction in value over time is taken for account by a Depreciation charge on the income statement. If a company buys a piece of equipment for $10 million dollars with an expected life of 10 years, the company will “charge off” $1 million dollars per year ($10 million divided by 10 years is $1 million per year) to reflect paying for that equipment. When the piece of equipment is initially purchased the company’s assets will increase by $10 million, and will drop by $1 million per year to reflect the decrease in value over time. This decrease is recorded on the income statement as a Depreciation charge.

 

Research and development – Research and Development is the money used to fund the creation of new products and innovations.

 

Operating Profit – Operating Profit is the difference between what a company sells its products for and how much those products cost to produce. This is an important indicator of how the company is controlling costs and how high (or low) profits will be. A higher margin (that is, higher operating profit compared to sales) means a company will make more money selling a product than a competitor. On Praxair’s Income Statement they refer to this as the company’s Operating Profit, it is also called Manufacturing Margin, Gross Margin or Gross Profit by other companies.

 

This can also be referred to in a percentage. A company may have a “20% Gross Margin” which means that their profit is 20% of the items sale price.

Lets go back to that bottle of Coca Cola in the earlier example. You paid $1 to buy a bottle of Coca Cola, that $1 gets reported as $1 in sales to Coca Cola. Now lets say it costs Coca Cola Company $0.10 for a plastic bottle and $0.20 for the ingredients to make the drink. These two expenses would be recorded as “Costs of Sales”. Lets assume Coca Cola spends $0.05 per bottle sold on research and development for new products, and has no depreciation or amortization charges.

 

Coca Cola Company’s Income Report would look like this:

 

Sales ………………………………………………..…………… $1

Costs Of Sales……………………….($0.10 + $0.20) = $0.30

Research and Development……..……………………..$0.05

 

Operating Profit ………………($1 – $0.30 – $0.05) = $0.65

Gross Margin = $0.65/$1 = .65 or 65%

 

Now this is a very simplified example. In reality Coca Cola Company has many more expenses. Last year Coca Cola had actual gross margins of about 23%. Meaning that for every $1 in sales, Coca Cola takes a 23 cent profit.

 

Interest expense– Interest Expense represents the amount of money the company paid in interest on its loans.

 

Net Income – Net Income is the profit of the company after all expenses are accounted for. Net income is operating profit minus all other expenses for the company, such as interest on its debt and taxes.

 

Net Income is commonly referred to as the “bottom line number”. Net Income represents the money left over from total sales after all expenses, taxes and interest payments are taken out.

 

 

Basic shares outstanding- This is the number of shares currently outstanding. This is used to calculate the company’s earnings per share.

 

Diluted shares outstanding- This is the number of shares that would exist if all outstanding stock options are exercised. This is used to calculate the diluted earnings per share, or a “worse case scenario” of EPS if all stock options are exercised.

 

Basic earnings per share (EPS) – EPS is the net income that each share of the company is responsible for.

 

To calculate Basic EPS:

 

 

 

Diluted earnings per share – is the net income that each share of the company is responsible for if all stock options are exercised.

 

To calculate Diluted EPS:

 

 

Investors can choose to use either basic or diluted number of shares in their calculations. Investors should note if the values of basic EPS and Diluted EPS are significantly different, as it is a sign on potential future dilution of the company’s stock and a possible decrease in stock price.

 

Evaluating a Company based on its Income Report

 

 

The Interest Report is full of useful information for a potential investor.

 

There are several basic ratios with these numbers that investors can use to compare companies to determine potential value.

 

P/E ratio – P/E or Price/Earnings ratio tells investors how much they are paying for a company’s profits.

P/E ratio is calculated by:

 

 

Using Praxair’s Income Report above, and a stock Price of $107.02 as shown above we can determine Praxair’s P/E ratio to be:

 

 

This means that for $1 in profit Praxair makes, investors pay $19.35 to buy the stock.

 

This is an example of a company’s “Trailing 12 months” or “TTM” P/E ratio. That is, you are using past earnings to calculate the ratio. Analysts also use future projected earnings to calculate a future P/E ratio, although be warned that it is calculated based on estimated future profits – something that is far from certain.

 

In principal the lower its P/E ratio is the more valuable its shares are to shareholders. For Praxair, you are buying a company for $19.35 for every $1 it makes in profit. If another company that did the same thing as Praxair (and had the same margins, growth rate, dividend etc) and had a P/E ratio of 10, that company would in theory be a better investment because you are paying less for the same amount of profits.

 

 

However, it is important not to put too much weight into only the P/E ratio. You should not make an investment solely because of a company’s P/E ratio. P/E ratios do not take into account the company’s growth rate, dividends or other important figures besides basic earnings and the stock price.

 

 

Price to Sales Ratio (P/S) – Price to Sales Ratio is another ratio developed to determine a company’s value. Some analysts like to use a Price to Sales ratio because companies can not ‘fudge’ their sales numbers as easy as their earnings numbers. It is hard for a company to fake sales, but relatively easy for a company to find some loophole or one time deductions to increase the net earnings number.

 

To calculate a Praxair’s P/S ratio using the information from its Income Report and stock price:

 

 

And using Praxair’s numbers from above:

 

 

Meaning that for every $1 in sales Praxair makes, you are paying $2.80 to buy the stock.

 

Like P/E ratio this is just one indication of value, and is far from a perfect indication of value. Like P/E ratio, with all other figures being equal, a smaller value indicates more value for shareholders.

 

However notice that this ratio does not take into account the company’s margins, meaning how much profit they make for each sale. A company with higher margins can justify a higher P/S ratio because they make more money per sale. P/S ratio can be a great way to initially find value, but be sure you examine the rest of the company’s income report before making an investment decision.

 

Return on Equity (ROE) - Return on Equity measures how much income a company generates based on its equity (Recall, equity is the amount of money a company received by selling its shares. Equity is the money investors have given the company). ROE is usually given as a percentage.

Two different companies may each have the same net income each year, but if one company has less equity than other, it means that that company is able to create profits using less equity. In other words, if a company can generate more profits from less investment, it is more efficient at creating profits.

 

Return on Equity is calculated by:

 

Shareholder’s Equity is found on a company’s balance sheet statement. Looking at Praxair’s Balance Sheet (discussed here) we see that Shareholder’s Equity for 2011 was about $5.5 Billion.

We can calculate Praxair’s ROE:

Or a 30.4% Return on Equity. Compare this result to other business in Praxair’s industry to see if Praxair is able to generate profits more efficiently than its competitors.

 

Return on Assets – ROA – ROA measures how much income a company generates from its assets. Like ROE, ROA is often given as a percentage.

 

Return on Assets is calculated by:

 

For 2011, we can calculate Praxair’s ROA to be:

 

Or 10.2%

 

Consider two companies that each have a net income of $1 billion per year. If one company has total assets of $100 billion and the other only $10 billion, the company with only $10 billion is able to generate much more income from its assets. That is, it is more efficient at using its assets to generate profit. ROA should be compared to the company’s competitors to see if profits are produced as efficiently as its competitors.

 

In Summary

 

All of these numbers by themselves can be of use for a potential investor.

Are sales increasing but profit decreasing? This could be a sign of a company struggling to control costs.

Is Income increasing but the share price dropping? This could be a sign of emerging value for investors.

 

It is important to understand the terms on a company’s Income Report because it is the lifeblood of companies and capitalism in general. Nothing is more basic and more important for investors than bottom line profit. If a business can not make money, it should not be invested in.

 

By being able to understand a company’s Income Report, you get a first hand look at a business’s books and can determine if the company has potential do be a solid investment.

 

 

Future articles at Begin To Invest will use these terms and more. This article covers only the basics of a company’s Income Report. Continue reading other articles as we delve into these reports in much more detail and find ways to uncover value in potential investments.

 

 

There are several resources that have helped me over the years in reading and understanding company income reports and financial statements:
The Interpretation of Financial Statements- By Benjamin Graham

This book is always by my side when I have company financial statements open. Gives real life examples, along with a great definitions section in the back of nearly every term you see on a financial statement.

Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports- By Thomas Ittelson

A very in depth guide for learning how to read company financial statements. The book contains real life examples of balance sheets, income statements and cash flows along with definitions of every term that will appear on those reports. This book walks you through the creation of a hypothetical company, “AppleSeed Enterprises, Inc” and how the balance sheet, income statement and cash flow statement evolve as the company grows. Great for investors of any level, and necessary to truly understand financial reports.

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