To the diligent investor, income statements analysis provides important insight into how effectively management is controlling expenses. Ratios are used to make rate comparisons of elements and data recorded on the statement. In our previous article about the format of an income statement, we showed you a basic income statement example. We will now bring that income statement to life by calculating some of the elements contained in it.
Income Statement Analysis
The first line of any income statements includes total sales revenue generated by a business during the time period specified in the heading. The expenses the company incurred in making those sales, or the cost of goods sold, is listed next and then deducted from revenue to give the gross profit figure.
That is pretty basic and simple, however we want to stay ahead of all these simple things on the income statements so they don’t pile up to make a complicated and confusing matter of this entirely straight-forward analysis procedure.
Gross Profit Margin (GPM)
Gross profit margin 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, 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 management that keeps 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 Profit Margin (OPM)
Operating profit margin is another measure of management efficiency included on income statements, 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.
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)
Interest coverage ratio 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.
Be sure to look at these items on the income statements when reviewing a company as a potential investment, and if you need a refresher on what an income statement looks like, view our income statement example in our previous article here.