The income statement is the next financial report that you will use to evaluate a company’s financial health. In this case, you are looking at how well the company is performing.
In general, you want to see the firm making a lot of money, but that should not be the end of your analysis. The income statement can help you determine if the company’s earnings are real, where these earnings are coming from, and if you can expect similar performance in the future. All three of those factors are important.
The first item you will use is revenue. Revenue is sometimes used to a way to measure the size of a company (especially private companies). For most companies, you will want to see a long period of revenue growth. Smaller companies will usually grow faster.
The accounting rules of the business are what determines when the revenue gets counted. It does not always match up with when the company is paid. When a sale is made, but the buyer pays with a “promise to pay” (which becomes accounts receivable), the revenue is counted but the company won’t benefit until it receives the cash. This can also work in reverse. A customer can pay for the company’s promise to deliver in the future. This is cash that comes in but is not yet counted as revenue.
With companies that offer a large number of products or cover a worldwide area, revenues are often divided into product segment or by region. This gives you the opportunity to see where the company is making most of its sales. For very large companies, some investors like to see at least 30% to 50% of the company’s sales coming from foreign locations, but this is not a requirement. When looking at individual product segments, it is important to evaluate each section as its own business, because what drives sales is usually different for each type of product.
Overall, sales numbers are most useful when they are not tied to short-term promotions. Sales generated by the natural business of the company are the ones you want to see.
There are two main types of expenses. Expenses that are part of producing the company’s product, (Cost of Goods Sold, or COGS), and expenses that are part of managing the business and selling the product (Selling, General & Administrative Expense, or SG&A).
Manufacturing firms and retailers usually have very high COGS. This leaves them with less money to spend managing the business and selling their product. It also gives them less flexibility for cutting their prices in the face of heavy competition.
Firms that spend a large amount of money developing new products, such as technology firms and pharmaceuticals, usually have a lower COGS and spend more money on advertising and overhead (higher SG&A). Firms with lower COGS tend to be more successful over the long run because they have more pricing flexibility, but high spending on SG&A can be a sign that the company is working too hard to generate sales or over-paying its management team.
The way SG&A costs are counted is also important. For example, when a company chooses not to count employee stock options as an expense, that is considered a way of hiding SG&A expenses to make them appear smaller than they really are. The report’s footnotes can be a helpful way of finding these details.
Overall, you will want to compare the company’s COGS and SG&A with others in its industry (the most useful form is expressed as a percentage of revenue). As a basic rule, lower is better.
iii. Operating Income vs. Non=Operating Income
The difference between a good company and a great company often comes from how much money is being spent and what it is being spent on.
Revenue and expenses can give you an even better picture of the company’s health when they are combined to show the company’s profit levels. However, it is important to distinguish between the incomes generated as part of the company’s normal business and the income (or expenses) generated by something that should never happen again.
There are two key adjustments for non-operating income. The first one is that you will need to subtract out non-operating income from total income so that you can get a more accurate picture of the company’s total business earnings. The second is that you should pay attention to what is being included in non-operating income and how often “extraordinary charges” occur.
Sometimes managers will attempt to hide a bad year by inflating expenses in the first quarter (making the rest of the year look better). Sometimes they will also include expenses in non-operating income that should be part of operating income. If you see several years with similar “non-recurring” expenses, this is a red flag.
Non-operating income is not bad by itself, but it may indicate future problems for the company if a large percentage of its profits or expenses come from activities outside the business.