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Income Statement or Profit and Loss Account Analysis | Financial Ratios

 




Corporate annual reports and interim documents fulfill transparency requirements while at the same time exposing commercial cost structures. Risk factors, legal proceedings, accounting policies, and a description of the business produce a compendium of disclosure. Accounting statements best describe corporate financial status along with management guidance; therefore, interpreting consolidated financial information included in Form 10-K is central to valuation.

Quantitative performance indicators demystify operational output for suppliers, analysts, creditors, and other stakeholders. For example, a supplier can comfortably extend credit to a company that's able to pay off debt as it comes due. Furthermore, investors increase return probabilities when lending capital according to a solid history of earnings retention and growth. Want to know expenses compared to generated revenue? That all begins with a look at the numbers.


Income Statement or Profit and Loss


The relationship between income and expenses determines profit and loss at the end of the accounting period. Because revenue is a priority for any business, this figure always appears first. Besides, one cannot subtract the cost of sales when there are no sales; nor can one determine gross profit, operating profit, EBIT, or net profit - all being the prime elements of any consolidated income statement. If expenses outweigh profits, then that company is operating at a loss, and vice versa.


Credit: The Art of Company Valuation and Financial Statement Analysis, Schmidlin 


Cost of Sales


Cost of sales or cost of goods sold highlights a small, yet confusing concept. When recording the cost of goods sold, that nominal figure relates to goods sold actually, and not additional inventory that would be considered assets until used in the actual sales process. For instance, let's say a business sells graphic T-shirts. Only the cost of T-shirts sold would go into the cost of sales rather than the entire inventory of T-shirts originally purchased to be sold. 

Sidenote: Accounting fraud often entails pre-recording figures for events that haven't happened yet, but more on that at another time.

Selling, General, and Administrative Expenses


Bringing in revenue feels great, and as long as there's a healthy range between the purchasing and sale of goods, then the company can post a considerable gross profit margin, remunerate investors and keep the lights on. This is ultimately how companies fund operating expenses, causing investors to pay extra special attention to this number. 

But running a business is tough and there are still more expenses to deduct from the gross profit margin, namely selling, general, and administrative expenses. These include mostly overhead costs such as rent, accounting functions, salaries, etc. SGA costs are generally fixed and reveal a lot about a certain business's cost structure. As an off-hand example, the SGA costs of a department store chain will look vastly different from a software company. One has heavier fixed costs than the other, therefore, comparing them would be an apple to oranges situation.

Depreciation Expenses

Money is an asset. When management purchases a new vehicle or any other piece of valuable equipment, it is initially described as an asset too. Accounting practices call for recording the transaction positively because an asset (cash) was traded for another asset. As time goes on, asset value naturally declines in accordance with the expected lifetime of the unit and depreciation charge. A quick, simple way to determine this charge is by dividing the purchase price by the unit's life expectancy (15-20 years for example). 

Financial Ratios and the Income Statement

Ratios in the form of fractions convert earnings and expense figures into bite-size details which open the door to all sorts of revelations about the business, the industry, and competitors. With that being said, financial ratios aren't the whole picture and should not be relied upon as a sole source of corporate intelligence. After some financial experience, it becomes evident why this is the case. These figures have a tendency to corroborate and other times conflict with one another.


Gross Profit Margin and Cost of Sales

The most important figure on the income statement is the gross profit margin ratio. Gross profit expressed as a revenue percentage spells out how well the company handles interest payments, taxes, and various overhead costs associated with doing business. In other words, an enterprise can't run if there are no profits.


We need to add the cost-of-sales ratio here as well since:

1) Cost-of-sales is generally the largest expense position

2) We need it to determine gross profit


Higher GP margins are good; great in fact. This means lower cost-of-sales and increased market power. 

Selling, General, and Administrative Ratio

Selling, general, and admin expenses compared to total revenues determine how well a company can weather a financial storm. Because SG&A numbers disclose rents and personnel expenses, or costs that are fixed, a sharp economic decline or low sales environment can dampen gross profits. 


Moreover, exorbitant administrative costs typically highlight inefficient management, but that isn't always the case. Investors and analysts have to consider rent pricing trends, salary-based developments, stock compensation, and distribution. 

Taxes

We are all aware of corporate tax rates and how they vary from country to country, and from business to business. Some companies are taxed based on pre-tax earnings while others are taxed according to dividend payments. Most interesting is how those tax rates affect profitability.



This subject is far too vast to cover, but a few crucial points need expressing:

1) The ability to forward losses for tax reasons alters corporate profitability moving forward

2) No matter the jurisdiction, the tax code is dependent upon policies over which corporations have minimal control

Key Takeaways


Want the most accurate information regarding corporate financial health? Start with the annual and interim reports, especially the income statement or the statement of profit and loss. Fundamentally, profits should be greater than losses. 

Revenue minus the cost-of-sales gives us the gross profit. Subtracting SG&A, depreciation, and research and development expenses equal the operating profit or EBIT. Take out the interest expense and income from the earnings and you have profit before taxes. Lessing the tax expenses from profits disclose the net profit.

Financial ratios are absolutely necessary for investors and analysts, but should never be the end-all-be-all.

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