Understanding the income statement

In this lesson we’ll look at the last of the financial statements you should scrutinise, before rounding up by explaining how to put all your analysis together and decide what to trade.

The income statement measures the company’s financial performance over a set timeframe. It’s based on a fundamental accounting equation:

Income = revenue – expenses

Effectively, the income statement is an accounting scorecard that illustrates the future profitability of the business, comparing the value of sales made with the cost of making them. Clearly, if making a sale costs you more than you earn from it, you have a fundamental flaw in your business model.

You might see the following items listed in the income statement:

• Net sales: the sales of goods and services to customers
• Cost of sales: the cost of producing the products sold. A manufacturer, for example, would include raw materials, labour and manufacturing overheads
• Gross profit: defined as total revenue minus the cost of goods sold
• Selling, general and administrative expenses: the company’s operational expenses. The trend of these expenses is viewed as a good guide to the efficiency of the management team
• Operating income: the company’s earnings before interest expense, taxes and special items
• Interest expense: demonstrates a company’s borrowings
• Pre-tax income: earnings before income tax. This is a good indicator of profitability
• Income taxes: an estimate of the income tax that the company expects to pay for the stated period
• Extraordinary expenses: write-offs against income, for example from restructuring or discontinued operations
• Net income: the bottom line, demonstrating the company’s profitability (or its losses)

Completing your analysis

So, having studied all the data and other information surrounding the company, finally it’s time to put it all together. As you’ll remember, the objective is to value the company, so you can assess whether it currently seems overpriced or underpriced.

By this point, you should be forming an opinion about whether the company seems positioned for growth or not. Does it have hidden potential, or are there pitfalls on the road ahead? Essentially, you’re looking to uncover any factors that may influence the company’s future, which haven’t yet been taken into account by the markets.

This stage of the analytical process isn’t an exact science. It’s more a case of sitting back and considering all the evidence as a whole, being as objective as possible.

While ‘gut feeling’ could play a part, it’s vital to consider whether you’re allowing any personal bias or emotional attachment to sway your judgment. For example, we all have our favourite brands, but your love for a particular company’s products doesn’t automatically make the stock a good investment.

You can find out more about avoiding bias and other emotional influences in our course, ‘The psychology of trading’.

Picking stocks

Over time you’ll develop your own preferred methods for choosing what to trade. Opinions differ about which data and ratios are the most significant, although some are commonly considered important.

For example, we mentioned the debt/equity ratio earlier in this course, and you might also look at price/sales, a valuation metric calculated by dividing a company’s market capitalisation by the most recent revenue number.

As the level of the share price is central to fundamental analysis, many analysts use ratios that include the current price. Keep in mind that a company’s stock price is equal to its market capitalisation divided by the number of shares issued.

Acting on your analysis

Having selected a share that you believe shows potential, the only remaining decision is how to trade it. There are two aspects to this:

Will you go long or short (buy or sell)?

Will you make a short-term trade or invest for the longer term

The first is simply a case of deciding whether you expect the share price to rise or to fall. The second depends both on your own goals – a fast profit, or gradual growth and dividend income – and on your expectations of the company.

Question

Let’s say you’re looking to trade in the short term, rather than holding a stock for a long-term investment. You’ve carried out analysis on two companies that both appear to offer potential for future growth:

• Company A has shown a sustained trend of gradually rising earnings over the past five years
• Company B’s net income has recently been hit by an extraordinary expense, spooking investors into a flurry of selling that has hit the share price

Which of these stocks is the best fit for your objectives?

• a Company A
• b Company B
• c Either A or B
• d Neither