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How To Analyse Financial Statements: The Income Statement

money Lately, we’ve been answering a host of investing-related questions posed by our readers in our ‘Ask A Foolish Question’ series. A bunch of those we’ve received pertain to the question of how to go about analysing financial statements.

Those are great questions – and important ones as well. At the Motley Fool Singapore, we aim to be part-owners of businesses and to understand them, we need to understand their numbers. That’s where knowledge of financial statements comes into play.

Every company has three financial statements: the balance sheet, the income statement, and the cash flow statement.

In an earlier article, we’ve gone through the balance sheet. Let’s get going here with the income statement.

At its simplest, the income statement gives us the sales and expenses of a company for a given period of time.

Unlike the balance sheet which is a snapshot in time, the income statement is cumulative; the amounts that are reported in the statement are cumulative totals for the period.

Let’s use supermarket retailer Dairy Farm Holdings (SGX: D01) financials for the six months ended 30 June 2013 as an example. Its income statement is recreated below:

  In US$m
Sales 5,102
Cost of Sales -3,601
Other Operating Income 75
Selling and Distribution costs -1136
Administration and Other Operating Expenses -183
Net Financing Charges -5
Share of results of associates and joint ventures 22
Pre-tax Profit 274
Taxes -43
After-Tax Profit 231
Shareholders’ Profit 228
Minority-Interests’ Share of Profit 2
Earnings Per Share (in US$) 0.1689

Source: Dairy Farm’s Earnings Release

The first line on the income statement is the sales (also known as revenue or top-line) brought in by the company for the reporting period. In Dairy Farm’s case, it brought in US$5.102b in sales for the first half of 2013.

As we work our way down, various expenses will be deducted from sales to leave us with different levels of profit. Just under the sales line, we have Cost of Sales. When applied to Dairy Farm, which operates supermarkets, it’s mostly used to mean the cost the company had to pay for the goods and products that it stocks its stores’ shelves with.

If we deduct Cost of Sales from Sales, we’re left with Dairy Farm’s gross profit, which equates to US$1.501b. Taking the ratio of gross profit to Sales gives us the company’s gross margin. Dividing US$1.501b by US$5.102b yields us a gross margin of 29.4% for Dairy Farm.

Moving on, we have the expenses that are involved with operating the business, such as staff salaries, transportation costs for goods, advertising expenses, and depreciation of its properties and equipment, among others. For Dairy Farm, these expenses fall under the various line items of Other Operating Income, Selling and Distribution Costs, and Administration and Other Operating Expenses.

Subtracting these expenses from gross profit leaves us with an operating profit of US$257m. The math is presented below for convenience:

Operating Profit = US$1.501b + US$75m – US$1136m – US$183m = US$257m.

Dividing operating profit by Sales leaves us with an operating margin of 5.0% for the company.

Next, we have expenses of US$5m that are related to interest payments for the various debt that the retailer owes. In addition, we also have profits of US$22m that come from the various joint ventures and other companies in which Dairy Farm has a minority interest in.

Accounting for these various items leaves us with the company’s Pre-Tax Profit of US$274m. In what should be a familiar routine now, dividing Pre-Tax Profit by Sales gives us Dairy Farm’s pre-tax profit margin of 5.4%.

Deducting taxes from Dairy Farm’s Pre-Tax Profit leaves us with its After-Tax Profit of US$231m.

We’re getting very close the bottom-line, or what’s otherwise known as profit. Not all of Dairy Farm’s After-Tax Profit actually accrues to its shareholders and from the table above, we can see that there’s US$2m that belongs to minority interests outside the company. That leaves US$228m as profit for the company’s owners, which is what’s commonly known as the bottom-line.

And of course, taking the ratio of Shareholder’s Profit to Sales will yield us Dairy Farm’s net profit margin of 4.5%.

If we divide the company’s bottom-line with the number of shares that exists, we end up with the earnings-per-share figure of US$0.1689, which is used in the calculation of the famous price-earnings ratio, a widely used valuation tool.

Now, the important thing about the income statement is the trend in a company’s top and bottom-line. Have they been growing or shrinking over the years? Ideally, we want to see the former as that would normally mean a business that’s becoming more intrinsically valuable for shareholders.

The various profit-margin figures can also be compared with those from previous years. Increasing margins would mean a company’s doing all the right things in terms of generating more sales and managing expenses. Decreasing margins might mean something’s not quite right with the company and investors ought to find out the reasons for it being so.

In addition, the margins of a company can also be compared with those of its competitors. Are they better or worse? Why is that so? Is there anything special within a company – such as a strong brand that gives its products pricing power or a strong workplace culture that focuses on eliminating unnecessary costs while refusing to sacrifice long-term competitive advantages for short-term gains – that makes its profit margins better than its peers?

Finally, it’s worthwhile to note that profit margins differ widely by industry.

Commodity-related companies like palm-oil producer Golden Agri-Resources (SGX: E5H) will generally have lower profit margins compared to a company like Singapore Exchange (SGX: S68) which operates the Mainboard and Catalist stock exchanges here in Singapore; the former does not have much control over the price of its main products while the latter operates almost monopolistically (companies that wants to access the public capital markets here will have to go through SGX, for instance), granting it a wide degree of pricing power.

But while GAR has the lower profit margins compared to SGX, it has had better share price returns over the five years ended 22 Sep 2013. According to Google Finance, the palm oil producer has returned 41% in that period while the stock exchange operator has only gained 13%.

This shows the importance of putting profit margins into context and why it’s not necessarily the simple case of being ‘the higher, the better’.

Foolish Bottom Line

What’ve we given here is useful in giving ourselves a head start in understanding financial statements. But truth be told, financial statement analysis itself entails a wide breadth of knowledge and is definitely not something that can be easily covered in its entirety in an article or two.

It would definitely serve an investor well to continue digging in further.

Stay tuned for the next (and last) article on how to analyse financial statements, where we’ll tackle the cash flow statement.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.