Income Statement Analysis

To a diligent investor, income statement analysis provides important insights into how effectively management is controlling expenses. Ratios are used to make rate comparisons of elements and data recorded on the statement.

The first line of an income statement reports total sales revenue generated by a business during the time period specified in the heading. The expenses the company incurred in making those sales (cost of goods sold), is listed next and then deducted from revenue to give the gross profit figure.

Total Revenue – Cost of Goods Sold = Gross Profit

That’s pretty basic and simple stuff, however we want to stay on top of all these simple and basic things so they don’t pile up to make a complicated and confusing matter of this entirely straight-forward analysis procedure.

Gross Profit Margin (GPM) is a percentage ratio measuring production and distribution efficiency. Simply calculate the percentage of revenue that remains after subtracting cost of goods sold. A higher GPM than a competitor or industry standard means the company is more efficient. Usually this number will remain consistent over time, so sudden large or irregular variations are reason for concern about accounting irregularities.

Operating Expense is the next income statement section. This consists of employee payroll, costs of research and development and miscellaneous charges to a company’s income. An investor will want to put money into managements that keep close control over operating expense, keeping it low without hindering the underlying business. Operating income or operating profit is income a company generates from its own operations only, and does not include income from investments or unusual extraneous revenues

Operating Income = gross profit – operating expenses

Operating Profit Margin (OPM) is another measure of management efficiency, comparing quality of a company’s operations to its competitors. Higher operating margins than the industry average indicates more flexibility or a broader range in determining price due to lower fixed costs and better gross margins.

OPM = operating income / total sales

Interest expense is the cost of borrowing money to build plants and offices, purchase inventory, or fund day-to-day operations. The borrowed money is converted to an asset on the Balance Sheet but, the actual interest paid is an expense because the company does not receive an asset for it. The cost of borrowing must be reported on the income statement as interest expense.

Interest Coverage Ratio (ICR) is a measure of the debt burden of a company. the number of times a company could make its interest payments from before tax and interest earnings. A heavy debt burden is indicated by a low ratio.

ICR = gross profit / interest expense