Investing by the Numbers – The Income Statement and Balance Sheet

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.

Henry offered to write explaining the basics of how to analyze balance sheets and financial statements. In Part  1, Henry analyzed the Income Statement. In Part 2, he continues with the Balance Sheet.

Looking at the Income Statement and Balance Sheet

Below is the basic components that comprise the income statement.  From there, I analyzed some common, but useful ratios to determine if the overall business is profitable and worth investing in.

Looking at the Income Statement and Balance Sheet

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 with creating revenue is considered the cost of revenue.  It can include labor costs, raw materials, or the wholesale price of goods.  In PG’s case, raw materials contribute the most to the 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 in 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 the cash margin.

Number of Shares

The number of shares represents the average number of shares outstanding during the reporting period.  I only look at diluted and not the 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 of 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 the 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.

Looking at the Balance Sheet

Now we continue onwards to the infamous balance sheet.  The balance sheet tells us how much a company owns (assets) and how much it owes (liabilities).  The difference between assets and liabilities is known as equity.

Equity = Assets – Liabilities

Equity represents shareholders’ ownership within the company.  The key thing to understand about the balance sheet is that it must be balanced at all times, hence the name.

Whenever possible, I’ll be referring to the financial statements of Procter & Gamble (PG-N), which can be found on Google Finance.

Year Return on Equity Return on Earnings Total Assets Total Liabilities Retained Earnings
2011 17.44% 16.69% $138,354 $70,714 $70,682
2010 20.84% 20.84% $128,172 $67,057 $64,614
2009 21.29% 21.32% $134,833 $71,734 $57,309
2008 17.38% 24.65% $143,992 $74,498 $48,986
2007 15.49% 24.74% $138,014 $71,254 $41,797
Year Total Equity Total Cash Total Debt Debt to Equity Liabilities to Assets
2011 $67,640 $2,768 $32,014 0.47 0.51
2010 $61,115 $2,879 $29,832 0.49 0.52
2009 $63,009 $4,871 $36,972 0.59 0.53
2008 $69,494 $3,541 $36,665 0.53 0.52
2007 $66,760 $5,556 $35,414 0.53 0.52

Accounts Receivable

These are pending bills for which the company expects to receive payment soon.  If accounts receivable is rising much faster than revenue, then this might raise some caution signs.  It means that the company is increasing revenue by booking sales for which it hasn’t yet received payment.

Inventories

Inventories consist of raw materials and goods that are ready or will be ready for sale.  Having a large amount of inventory in storage is not a good sign since inventory soaks up capital and can’t be used for anything else.  Increasing inventory can be especially troubling in the retail sector.  For example, a retailer that needed to sell last season’s fashion line would likely have to significantly mark down their goods.  Meanwhile, a construction company could probably get a decent price if it needed to sell some construction equipment.  It’s always good to keep a watchful eye for increasing inventory.

Inventory Turnover

The faster a company can sell its inventory, the greater the impact on profitability.  A high inventory turnover frees up cash and makes it useful elsewhere.  The equation for inventory turnover is:

Inventory Turnover = Cost of Revenue / Inventories

For example, in 2011 PG’s cost of revenue and inventories were $40.77 and $7.38 billion, respectively.  Thus the inventory turnover rate is 5.52.  This means PG went through its entire inventory 5.52 times over the course of the year.

Property, Plant, and Equipment (PP&E)

These are long-term assets that form the infrastructure of the company.  They include land, buildings, factories, furniture, equipment, etc.  At the end of the fiscal year 2011, PG had recorded $41.51 billion in PP&E on the balance sheet.

Total Cash

Total cash includes: cash and equivalents, short-term investments, and long-term investments

Total Cash = Cash & Equivalents + Short-Term Investments + Long-Term Investments

Cash and equivalents and short-term investments are money the company allocates in low-risk and fairly liquid investments.  Long-term investments are money invested in either longer-term bonds or in the stock of other companies.

In 2011, PG had $2.77 billion in cash and short-term investments and zero in long-term investments.  Most companies don’t have enough cash on the balance sheet to matter, except for the technology sector, so total cash really isn’t a significant factor.

Accounts Payable

These are bills the company owes and are due within a year.  Large companies that have higher leverage over their supplies can extend their payment deadline.  Extending the payment deadline can be good for cash flow because the company tends to hold onto cash longer.

Total Debt

Total Debt includes short-term debt, long-term debt, and capital leases.

Total Debt = Short-Term Debt + Long-Term Debt + Capital Leases

Short-term debt and capital leases refer to money the company has borrowed for a term of less than a year.  These items can become troublesome when the company’s bills are due and it doesn’t have the money to pay them.  PG short-term borrowings were $9.98 billion in 2011.  The company generates enough operating cash flow, roughly $13.23 billion, to satisfy any short-term obligations.

Long-term debt is debt obligations such as bonds and notes, which have maturities greater than one year.  In 2011, PG accumulated $22.03 billion in long-term debt.  Overall, the company has $32.01 billion in debt as of 2011.

Retained Earnings

Retained earnings record the amount of capital a company has generated over its lifetime, minus dividends and stock buybacks.  I usually reference retained earnings before equity because it’s a better measurement for a company’s long-term track record at generating profits.  Retained earnings are a cumulative account; each year that the company makes a profit and doesn’t pay it all out as dividends retained earnings increases.  If a company has lost money over time, retained earnings can turn negative and create an “accumulated deficit”.

For example, Microsoft had an accumulated deficit and equity of -$6.33 billion and $57.08 billion, respectively in 2011.  The accumulated deficit was the result of the special dividend paid in the second quarter of 2005 and common stock repurchased.  However, this won’t hinder the company’s ability to operate or repay debt given its continuing profitability and strong cash flow.

Debt to Equity

This is a measure of a company’s financial leverage.  It’s calculated as:

Debt to Equity = Total Debt / Equity

Ideally, I like the debt to equity to be zero.  But realistically anything below 0.60 is relatively good for large companies.  PG has managed to maintain a debt to equity ratio of 0.52 over the past five years.  Some companies, such as Colgate-Palmolive, Philip Morris International, and IBM, have a debt to equity exceeding 1.  This is perfectly fine because these companies generate plenty of operating cash flow to fund their debt.

Return on Equity (ROE)

This is the amount of net income returned as a percentage of shareholders equity.  Return on equity measures a company’s profitability by revealing how much profit a company generates with the money shareholders have invested.  It is calculated as:

Return on Equity = Net Income / Equity

PG has maintained a 19.00% ROE from 2007 to 2011.  In other words, if I give PG $1, I can expect to receive $1.19 or a 19.00% return on my investment.  But this isn’t necessarily true as ROE can be skewed due to debt.  Companies such as Colgate-Palmolive and Philip Morris International have a ROE of more than 90%.  Just be careful when using this metric to analyze a company’s intrinsic value.  The values can often be skewed due to highly leveraged debt.

Return on Retained Earnings (RORE)

Since ROE can be skewed by high leveraged debt, I prefer using RORE instead.  It is calculated as:

Return on Retained Earnings = Net Income / Retained Earnings

Retained earnings are a percentage of earnings not paid out as dividends but retained by the company to be reinvested in its core business or to pay the debt.  Hence, this variable excludes debt from the equation, unlike equity, and provides a more accurate calculation in my opinion.  P&G averaged a 21.65% RORE over the past five years, which is relative to its 18.49% ROE.  In 2010, Colgate-Palmolive had an 82.36% ROE, but its RORE was 15.37%.  We can clearly see the difference when leveraged debt is excluded from the calculations.  However, there’s no need to worry about Colgate-Palmolive’s finances.  The company generates enough cash flow to manage its debt.

Looking at the Income Statement and Balance Sheet

16 Responses to “Investing by the Numbers – The Income Statement and Balance Sheet”

  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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