Income Data Analysis

Understanding the Income Statement

The income statement is a document that shows you the profit and loss of the company over a specified period. It has been most commonly referred to as the “Profit and Loss Statement,” but both names are now in use. Its primary function is to express the net income by comparing revenues and expenses. You will often see this written as follows:

Net Income = (Total Revenues + Profit) – (Total Expenses + Loss)

The income statement will include other values that shape this core value:

• Revenues or Sales
• Cost of Goods Sold
• Gross Profit
• Expenses
• Pre-tax Earnings
• Taxes
• Net Earnings

Some of these values are straightforward, and some are more complex. Revenues or sales are the total amount of money received. Cost of goods sold is the upfront amount paid for purchasing the necessary materials or paying labor costs, or in other words, the direct cost of what is needed to make the product offered for sale. Gross profit refers to the monetary amount obtained after paying the cost of goods sold. Expenses are the financial amount required to operate the entire scope of the business.

Most of these figures depend on one another, and they can be used to assess many features of the company. For example, you can subtract the cost of goods sold from revenues to arrive at gross profit. From gross profit, you can subtract expenses to arrive at pre-tax earnings. Then you can subtract the amount of taxes from pre-tax earnings to reveal net earnings or losses.

Analyzing the Income Statement

Investors can use the analysis of the income statement to calculate financial ratios that can be used to compare the same company over the years or to compare it to another company. For example, you can compare the profits of one company with the profits of its competitors by looking at several figures that express margins, such as gross profit margin, operating profit margin, and net profit margin. Or you can compare the earnings per share (EPS) of one company with any other company to show you what a shareholder would receive in case assets were liquidated or if each company distributed its net earnings.

Vertical Analysis

When you compare each line in the statement to the top line (which is revenues), this is referred to as “vertical analysis.” Each item in the statement becomes a percentage of the base number. This method can be used to easily compare one item to another, such as checking how each item affects cash flow, or it can be used to demonstrate how one item’s cost compares to the cost of any other item.

Horizontal Analysis

In contrast, horizontal analysis compares the same item over two or more time periods. This method is most often used to discover trends. One item can be observed over a long period to see changes from year to year. For example, you may want to focus on the factors that could drive the success (or failure) of a particular company over the past few years. Some investors use this method to predict the company’s performance in the coming months or years.

Limitations of the Income Statement

Because the income statement has some limitations, it may not always be the best source of consultation. It depends on what you are looking for. Capital structure and cash flow, to name just two, are critical factors in a company’s success or failure, and you will want to have accurate numbers.

Not the Whole Picture

While the income statement provides a lot of detail, it does not cover the whole picture. The most notable absence is in the form of cash, whether it be cash or credit card. The income statement does not reflect whether sales were made in cash or by credit card, for example. The same applies to payments. Therefore, there is no real way to know the amount of cash available at any particular moment or the amount of cash due to be received.

No

Existence of Exact Numbers

Since the income statement aims to provide a complete picture or overview, it often relies on the use of estimates rather than exact numbers. To explain this, companies may have to make quick decisions to deal with daily operations and make sound decisions. They need to be able to effectively assess general concepts in order to perform well, or they may need to anticipate future needs to make current decisions.

Word of Caution

Because income statements do not always present the most accurate numbers, there is always a chance for misrepresentation. Whether intentional or accidental, numbers can be manipulated. When preparing an income statement, higher or lower numbers than necessary may be used. When reading it, you have no real way of knowing the exact figures. You cannot be sure if there are any unscrupulous motives at play.

Although estimates are necessary, and errors can occur without malice, they can also happen intentionally. There are many reasons a company might want to report an increase or decrease in figures such as losses or profits, and if they do so without solid numbers to back their claims, it is considered fraud.

When considering income statements, be sure to note that each company can differ in accounting methods. Some may use “first in, first out” (FIFO), while others may use “last in, first out” (LIFO). This will affect the numbers you may be trying to compare.

Source: https://www.thebalancemoney.com/investing-lesson-4-income-statement-analysis-357580