How to Understand an Income Statement: Part 2

In Part 1, I shared what an income statement is and how I identify companies that are truly profitable from others that are not.

Now, from an investor’s point of view, I do not want to invest in a company that is profitable only in a single year, just to find out that it has failed to remain profitable in the following years. So, how do we avoid potential disappointments in our investments? The key is to find businesses that are consistent with growing profits.

In Part 2 here, I will share three simple tricks to find companies that are consistent and eliminate those which are not.

Read 5 – 10 Years’ Worth of Income Statements

Firstly, an investor would want to know whether a firm has built a track record of growing sales, operating profits and shareholders’ earnings over the long-term. Thus, I would compile these figures for an extended period (five to 10 years) to assess whether a business is consistently doing well.

Why is this important? This is because a business that is consistently profitable tends to replicate its financial success in the immediate future.

Also, I find it easier to estimate its intrinsic value, calculate its historical price-to-earnings ratio and its estimated dividend yields for stocks that are consistently profitable. It would be difficult to value a stock which is unpredictable in its financial results.

Read the Latest 12 Months of Income Statement

Secondly, I would check the company’s quarterly profits over the last 12 months. Why? This is because there is no guarantee of ensuring that the firm will continue to sustain growth in profits although it has built an impressive track record of profits in the past.

Stocks that are attractive to investors are ones that grow profits consistently. You can only tell whether a business has grown profits consistently by tracking its income statement for the past five to 10 years (long-term) and the last 12 months (short-term). In most cases, an investor would dismiss a firm if it has been unprofitable or has reported strings of profit declines over both the long-term and short-term.

Profits with Positive Operating Cash Flows

Thirdly, I will check the firm’s cash flow from operations over the past five to 10 years (long-term) and the last 12 months (short-term). It is important for profitable companies to also report positive cash flow generation from their operating activities.

Why? Firstly, it is harder to “fake” cash transactions. It would be alarming to find a business that is consistently having cash flow problems if it is consistently profitable. Usually, investors would dismiss these stocks as their accounts may be viewed in suspicion.

Secondly, theoretically, a stock is supposed to grow their bank accounts as they become increasingly profitable. It enables them to use these cash to lower their debt obligations, invest to expand for the future or pay out dividends. Thus, it is always a good thing to make sure a company’s profits are in tandem with the growth in its bank accounts.

The Foolish Takeaway

By applying all the tips in both Part 1 and 2, you can eliminate 90% of the investment mistakes made by most people who lose money in the stock market. Also, you would enhance your chances of making consistent profits from stock investing.

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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 Stanley Lim doesn’t own shares in any companies mentioned.