It’s All About the Numbers – Part 1: The Income Statement

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
2011 $57,838 $41,791 $15,818 $11,797 $9,925
2010 $43,232 $41,019 $16,021 $12,736 $13,005
2009 $43,251 $38,004 $15,374 $13,436 $11,681
2008 $39,474 $39,996 $15,979 $12,075 $11,962
2007 $35,137 $37,065 $14,485 $10,340 $10,465
Year Gross Margin Operating Margin Net Margin Cash Margin EPS Outstanding
2011 50.62% 19.16% 14.29% 12.02% $3.93 3002
2010 51.96% 20.30% 16.13% 16.47% $3.53 3009
2009 49.55% 20.05% 17.52% 15.23% $3.39 3154
2008 50.46% 20.16% 15.24% 15.09% $3.40 3319
2007 51.15% 20.00% 14.27% 14.45% $2.84 3399

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!

Total Revenue

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.

Gross Profit

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

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.

Operating Income

Total revenue minus total operating expense equals operating income.  This represents the profit the company made from its actual operations.

Operating Margin

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.

Net Income

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.

Net Margin

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

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!

16 Responses to “It’s All About the Numbers – Part 1: The Income Statement”

  1. The Dividend Ninja

    Oct 31. 2011

    Henry Thank you for taking the time to write this valuable post, and help readers better understand how to interpret financial statements. Much appreciated!

  2. Henry Le

    Oct 31. 2011

    Avrom,

    No problem! Thanks for giving me the opportunity to write for your readers. =)

  3. FrankP

    Oct 31. 2011

    Great blog and thanks for the guest post. Looking forward to the others in the series.

  4. Eddie

    Nov 01. 2011

    Great post by Henry!
    Funny enough everyone talks about different investing options and where to invest your money, but fails to get into the basics, ie: Reading the Income Statement.

    Great post for a newbie investor like me.

  5. The Dividend Ninja

    Nov 01. 2011

    Eddie You and me both! I second that 🙂

    FrankP Cheers!

  6. Dividend Mantra

    Nov 01. 2011

    Great job Henry!

    Kudos to Ninja for allowing Henry this guest post.

    I really liked this and I’m a bit embarrassed. I obviously write about dividend investing as part of my journey to financial independence and I’ve never written about basics like this.

    Great stuff! Thanks Henry.

  7. The Dividend Ninja

    Nov 01. 2011

    Mantra Thanx for posting. Nothing to be embarrassed about becuase you probably know far more about balance sheets and income statements than I do 😉 For you these might be basics, but for many other investors it’s definitely overwhelming stuff to even grasp, never mind to learn. That’s why I was delighted for Henry to write this article!

  8. My Own Advisor

    Nov 01. 2011

    I echo that – kudos to Ninja for allowing Henry to do the guest post!

    Nicely done – Henry you did a great job with these metrics!

    Will tweet my friend 🙂

    Mark

  9. Henry Le

    Nov 02. 2011

    I’m working on the second part and hope to have it finish soon. Thanks everyone for your sincere comments!

  10. Wizzle

    Mar 04. 2012

    First of all hello!

    As a beginning investor I am glad to have come upon this blog. There is a lot of hulpful, clear and fundamental information to be found here.

    I was doing some calculation of my own with the above income statement of PG. Either I didn’t understand it completely or there is a mistake in the Total Revenue. With the numbers displayed in the table above, the Gross Margin, for say 2011, would be 41791/57838*100= 72,25% instead of 50,62%.

    Did I not understand the income statement correctly or is there a little mistake in this one?

    Gr,

    Wizzle

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