The following is a guest post from Henry Le, who blogs about investing at PaperCroc. I was delighted when Henry offered to write a series of posts, explaining the basics of how to analyze balance sheets and financial statements.
The Income Statement
Numbers can tell you many things. In this case, numbers can tell you about the financial health of companies. And healthy companies have healthy financials. Financial statements are split into three parts: the income statement, balance sheet and cash flow statement. In this post, I’ll look at the income statement.
Whenever possible, I’ll be referring to the financial statements of Procter & Gamble (PG-N), which can be found on Google Finance.
|Year||Total Revenue||Gross Profit||Operating Income||Net Income||Free CashFlow|
|Year||Gross Margin||Operating Margin||Net Margin||Cash Margin||EPS||Outstanding|
The income statement basically tells us how much a company is making or losing. At first glance, any financial statement can look overwhelming. But Google Finance has made it easy for us by bolding the important information. We’ll also be discussing margins. You often hear people talk about a company’s margins. Just remember, higher margins are always better. Also, I’ll be looking at the annual and not quarterly statements. So let’s get started!
This is simply how much money the company made in during the year. For more detail analysis, visit the company’s website to read the full annual reports. From 2007 to 2011, PG’s total revenue increased from $35,137 to $57,838 billion. That’s an 86% increase, pretty good for a blue-chip company.
Cost of Revenue
Any expense associated in creating revenue is considered cost of revenue. It can include labor costs, raw materials, or wholesale price of goods. In PG’s case, raw materials contribute the most to cost of revenue.
Total revenue minus cost of revenue equals gross profit. It essentially tells us how much a company is able to mark up its goods. PG’s gross profit increased year over year and its gross margin remained steady at around 50.00%.
Gross margin is just a percentage of gross profit. It’s calculated by dividing gross profit over total revenue. For example, in 2011 PG had total revenue of $82.56 billion. Its gross profit was $41.79 billion. So the gross margin is 50.62%. High gross margin allows companies to have pricing power.
PG is able to mark up its products by a whopping 101.24%. So if commodity prices rise, PG can pass on that cost to the consumer because it has strong brand recognition and high gross margins.
Total revenue minus total operating expense equals operating income. This represents the profit the company made from its actual operations.
This is calculated by dividing operating income over total revenue. If a company’s margin is increasing, it is earning more per dollar on sales. Remember, the higher the margin, the better. Generally, I like operating margin to increase or remain stable year over year. PG’s operating margins are around 20% as its revenue steadily increased over the past five years.
This number represents the company’s profit after all expenses and taxes have been paid. It’s the number a company will usually highlight in their earnings report.
This ratio expresses how much of each dollar earned by a company is translated into profits. It’s calculated as net income divided by total revenue. Net margin can vary from industry to industry. So it’s best to compare companies within the same industry.
Cash margin is calculated as free cash flow divided by total revenue. Free cash flow is calculated by subtracting operating cash flow from capital expenditures. Both of which can be found in the cash flow statement (which I’ll cover in Part 3). I believe this is the best proxy for determining if a company is profitable or not.
The advantage of using free cash flow is it’s not as easily manipulated as net income. Cash margin calculates all the cash flowing into the company during the reporting period. Meanwhile, net margin calculates money the company received or expects to receive during that period. And what the company expects to receive, it might not be received at all. That’s why I like cash margin.
Number of Shares
Number of shares represents the average number of shares outstanding during the reporting period. I only look at diluted and not basic number of shares. This is because diluted shares include securities that could potentially be converted into shares of stock, such as stock options and convertible bonds. Meanwhile, basic shares include only actual shares of stocks, so I completely ignore basic shares. Typically, the number of shares should decrease year over year because company repurchase outstanding shares. PG’s outstanding shares decreased from 3.4 billion to 3.0 billion over the past 5 years.
Earnings per Share (EPS)
Once again, I look at diluted (EPS) only. EPS is calculated from net income divided by number of shares. This is another number company’s highlight in their reports. It’s important, but it can be easily manipulated. For example, the net income can stay flat, but if outstanding shares decrease due to buybacks then EPS will increase. That’s why we have to compare EPS to the free cash flow, which will be explained later.
Hopefully, my post was helpful. In the next post, I’ll go over the balance sheet and finally the cash flow statement. Questions are very welcome! Ask them in the comments and I’ll try my best to answer them. Cheers!
Henry Le blogs about investing, life, and the pursuit of early retirement over at PaperCroc. He is your average investor and strongly believes investing is a great tool to building wealth. Stop by his website and follow his investing journey!