- Part 3: Understanding the Balance Sheet - June 12, 2016
- Part 2: How well you performed – The Income Statement - May 15, 2016
- Part 1: Your quick guide to financial statements - April 27, 2016
The season of Annual General Meetings (AGMs) has just passed…
For those of you who invest, you might have been rather busy over the last month or so analyzing your company’s financials, rubbing your hands with delight and thinking how you are going to grill your company’s Board of Directors over last year’s financial figures.
Or maybe you’re rushing for the buffet spread?
For those who are just starting to invest and don’t have such depth of knowledge, fret not.
In the first part of our Accounting Principles series, we talked about how we can efficiently interpret the financial statements of a company. To be able to invest wisely, we need to have a solid foundation about accounting principles and what these principles mean in the context of the financial statements.
Here is a quick overview about what these 3 statements are:
The Income Statement
Today, we delve deep into the income statement, which very simply shows how well a company has been doing over the course of the year.
Just like how we measure our salary and expenses in a year, a company’s performance over a year is measured in the income statement. As you can tell, the income statement of a company is produced yearly. There are a few basic things we should know about the income statement. Don’t worry, it’s simple and straightforward:
1. Two types of ‘lines‘: Top-line and Bottom-line
Investors typically look for two figures: Revenue and Net Profit. The income statement typically starts with Revenue and goes on to deduct various expenses to derive a Net Profit figure. Therefore, revenue is known as the top line and net profit the bottom line.
These are some typical items found in an income statement
Be clear that a company’s revenue figures only reflect what it has earned from its core operating business. This means that earnings derived from other sources are not reflected in revenue. Rather, they are reflected under another line item called “other income”.
For example, interest or investment income earned by a construction company is not reflected under revenue – only what it receives from its construction activities.
2. What to look out for
What, therefore, should we look out for when we look at income statements? We might all be confused with the various figures and if we’re bad at math, this totally puts us off.
For starters, we can analyze the income statement using financial ratios. Rather than using absolute revenue or profit figures, ratios give us a relative indication of a company’s performance. This gives us a true account of performance, taking into account any limitations or constraints. Some relevant ratios are:
- Net Profit Margin (Net profit divided by Revenue)
- Gross Margin (Cost of goods sold divided by Revenue)
Another way we can look at financial statements is by analyzing trends. A healthy company should be demonstrating health revenue and net profit growth. Typically, investors can perform trend analysis for a 10 year period.
3. Accounting basis vs Cash basis
The final but most important thing to know is that accounting profits do not equate to cash flow for the firm! To illustrate this, if a firm earns $100 in accounting revenue but receives cash only in the next financial year! Assuming this is the only transaction in the year, this means that the net profit figure stated at the end of the year is ‘non-existent’. It is short of $100 in cash!
As mentioned before, this is why many firms that shut down are actually making accounting profits, and how unprofitable firms can still survive – it’s all about the cash flow; and as they say, “Cash is King”!
This is a brief but insightful overview of a company’s financial statements. Ping me if you want to know more and I’ll be glad to help!
Follow me on this series, Accounting Principles, as we delve deep into understanding a company’s financials: