Stock Market Essentials: The Income Statement
How To Analyse An Income Statement
Analysing a company’s income statement is one way in which you can determine how much profit a company is making.
In terms of stock market investing, this information can then be used to help you make your investment decisions.
You can calculate profit using the following equation:
Sales - Expenses = Net Profit
What Is On An Income Statement?
You should pay attention to the following items on an income statement:
Sales
A healthy company should show signs of increasing sales, which will, over time, translate to higher stock value on the stock market.
Ideally, sales should be increasing by around 10 percent each year. The higher this percentage, the more profit a company is making and the quicker it is likely to grow.
Expenses
Expenses are an extremely important aspect of any income statement because they give you an indication as to the financial health of a company.
If for example a company has many expenses but very little income, they are likely to get themselves into debt if they are not already.
Always pay attention to rising expenses, as this will eventually translate into lower stock price on the stock market.
Research And Development (R&D)
Certain companies such as biotech and pharmaceutical firms spend a lot of money on R&D. The reason for this is that such research translates into the development of new products which will then be sold later to consumers.
Over time, R&D should ensure that the company remains financially sound and experiences positive growth.
Therefore, when investing in such companies in the stock market, check to see how much they are investing into R&D.
If their success depends upon R&D but they are not spending much money on it, you may want to look elsewhere.
Earnings
Ultimately, the long term financial health of a company is dependent upon its earnings.
Look for companies that show increasing earnings year after year, as these are likely to experience increasing stock value in the stock market.
Once you are able to understand an income statement, you should then be able to answer the following questions:
1 - What Sales Did A Company Make?
The goods or services a company provides generate revenue. What is the company selling, and how long are they likely to sell it before demand falls?
2 - What Expenses Did A Company Incur?
Although sales can generate profit, they also generate various expenses. For example, payroll, utilities, advertising and administration can all be involved during the selling process.
As a stock market investor, you should be particularly interested in whether these expenses are rising from year to year.
If they are, will they ever be controlled? Or will they continue to increase and ultimately threaten the financial future of that company and ultimately their stock value?
Analysing a company’s income statement should give you a good idea about whether or not it will be a good investment for you.
The following information provides more details about understanding sales, expenses and the profits of a company.
Sales
Sales refer to the money that a company makes from selling its good or services. When you analyse an income statement and look at sales it is called top line analysis.
As a stock market investor, pay attention to the following points about sales:
Increasing Sales
A healthy company that is growing will have increasing sales. Look for an increase of around 10 percent each year.
Core Sales
Core sales are the sale of products or services that the company specialises in. These should be increasing at a rate around 10 percent each year.
Core sales are important, because when the core sales of a company decline, that company is likely to suffer as a result.
How Does A Company Calculate Sales?
In the late 1990s some companies boosted their sales by offering affordable financing with easy repayment terms.
Although such a sales increase may look impressive at first glance, if you analyse the income statement and discover it was built on credit that the company extended to buyers, the long term stability of that company is brought into question.
Expenses
How much money a company spends, its expenses, has a direct relationship with the amount of profit it makes.
If spending is not controlled to a sustainable level, ultimately that company will fall and their stock prices will fall in stock market.
Pay particular attention to the following points when examining the expenses of a company:
Compare Present To Past Expenses
Check to see whether expenses are rising from year to year, or whether they are decreasing.
A healthy company with a strong financial future tends to show decreasing expenses, whereas a company whoes future is in jeopardy tends to show increasing expenses.
Are Some Expenses Too High?
Often when you break down expenses you will find that a small number of items account for the majority of the expenses.
Find out what these are, and why they are causing such high expenses. Will these expenses increase in future?
Profit
Profit is the most important factor to consider when analysing an income statement.
A company that experiences increasing profit from year to year is likely to have an increasing stock value and will perform well in the stock market.
A company that experiences decreasing profit from year to year is likely to have an decreasing stock value and will perform poorly in the stock market.
Your success as a stock market investor is largely dependent on your ability to spot the companies which are likely to make large profits in the future, even though they may not be right now.
