Analyzing Income Statements

While there are many reporting standards that are in-place such as GAAP (Generally Accepted Accounting Principles), as well as guidance published by the FASB (Financial Accounting Standards Board); this does not mean the income statement is without limitations. In fact, it has at least two weaknesses.

Accounting Data

One criticism of the income statement has to do with the fact it does not tell the user what might happen in the future. By its very nature, the income statement provides a glimpse into the history of the company's operations. The income statement also doesn't provide the analyst with any information about factors that might affect the future growth of the company. New products that are in the pipeline, market expansion, and competitive advantages; none of these factors appear on the income statement since it is limited to accounting data.

Accounting Methods

The second limitation of the income statement has to do with the flexibility companies have with respect to choosing an acceptable accounting method. Depreciation is a good example of how the chosen method can affect net income. For example, if a company decides to accelerate depreciation, they hurt short-term net income and earnings (depreciation expense is larger). If they use straight line depreciation, net income in earlier years will be higher. But it will be lower in the future (all things being equal). Market analysts pay careful attention to these details because it can tell them a lot about the quality of earnings. A company may choose to use more liberal accounting methods to increase short-term performance; unfortunately, this is not a rare practice.

When investors analyze a stock, the first and arguably most important factor they look at is earnings, which are usually stated in terms of earnings per share. They are also going to look at certain financial ratios such as dividend yield, price to earnings ratio (P/E ratio), operating expense ratio, and return on investment.

The income statement also doesn't provide any information about factors that might affect the future growth of the company. The income statement is limited to accounting data.

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Each of these measures can be found by analyzing data appearing on the income statement. The following is a brief overview of each measure.

Earnings Per Share

Earnings per share (EPS) is defined as the net income (or profits) of a company divided by the shares of common stock outstanding. Earnings per share tell the analyst how much money is available to shareholders, after taxes, and "normalizing" those profits by stating them on a per share basis. Earnings per share can be calculated using the following formula: (Net Income - Preferred Dividends) / Shares of Stock Outstanding

Price to Earnings Ratio

The price to earnings ratio, or P/E ratio, is the stock's price divided by the latest 12 months of earnings per share. The P/E ratio is an indicator of the premium paid for a stock, and is also an indicator of future growth expectations. A relatively high P/E ratio indicates a higher premium for the stock's "potential" future earnings. The formula for price to earnings is as follows: Market Value of Stock / Earnings per Share

Dividend Yield

While dividends are important to some investors, they are often a secondary consideration to others. Those that cherish dividends are usually interested in receiving a steady stream of income each year. Investors that are less concerned about dividends are usually seeking stocks that are reinvesting in their company, and have adopted a growth strategy. These individuals are seeking stock price appreciation and capital gains. Dividend yield is calculated in the following manner: (Dividends per Share / Market Value of Stock) x 100 The dividend yield shows the rate earned, based on the current market value of the company's stock.

Operating Expense Ratio

The operating expense ratio is a measure that is often used to figure out how well a company is able to control their operating costs. The operating expense ratio is a good example of a comparative measure. This means it's necessary to analyze this data using a comparative income statement (one containing multiple years) and examine the trend in operating expense ratio. Operating expense ratio is calculated using the following formula: Operating Expense / Net Sales The lower the ratio, the better the company is performing. A favorable trend would be one where the ratio is declining, while an unfavorable trend would be one where the ratio is increasing.

Return on Investment

In this context, return on investment is a measure of a company's ability to use their available resources efficiently. While there are several measures of this type, each using a different divisor, the most useful measure is return on total assets. Return on total assets is calculated as: (Net Income + Interest Expense) / Total Average Assets The total average assets can be found by adding the total assets at the beginning of the year plus the total assets at the end of year, then dividing by two to find the average. Return on total assets is another example of a comparative measure.

Lenders need reassurance they're going to be repaid money owed. They're investing in a company, and creditors can use the income statement to gain a better understanding if a company is financially healthy enough to repay a loan. From the company's standpoint, they are willing to borrow money as long as the rate of return earned on that money is higher than the cost of borrowing. When this occurs (rate of return > cost to borrow), then shareholders benefit by this use of leverage. Leverage is simply buying assets with money raised by borrowing, or by issuing preferred stock. The downside of leverage occurs when the rate of return on an investment is lower than the cost of borrowing. When this happens, leverage lowers net income and therefore earnings per share.

We discuss several different measures of leverage in our article on Understanding Financial Ratios. There is one very important leverage measure that can be found by examining data on the income statement: times interest earned. The number of times interest earned is a measure of how "easy" it is for a company to cover its debt payments. This measure is also called the interest coverage ratio or coverage ratio. Creditors can calculate times interest earned from the income statement using: Net Income / Annual Interest Expense This ratio should always be above 1.0 and the higher the ratio, the better. If a company has no debt, then it's not possible to calculate this measure, and leverage is not a concern.

The focus of this article was the income statement. We talked about the strengths and weaknesses of this report, as well as the financial ratios that can be calculated using information appearing on this statement. It's also a supplemental article to Understanding Net Income, where we explain the elements appearing on the income statement. Finally, we're going to finish this series with a discussion of how to construct an income statement.