Income Statement Analysis

• Shows there revenus, expenses and income recognized over a period of time. 
• Revenue - Expenses = Income
• Use accrual accounting - capture when revenue & expenses occured (as opposed to cash based accounting, when cash is transferred)
• Present most important figure - earning per share (EPS) 
• A firm worth is depend on its ability to earn money and generate future cash flows
• reported earning that differ (+ve or -ve) from expectations can cause large movements in stock price.
• Five-Step Format - revenue, gross profit, operating income, income before tax, net profit
• Prdocut have been delivered / service hase been rendered = revenue  
• some companies estimate an allowance for future returns & report the net revenue
• multi-year subscription (e.g. software) should not recognize the entire sum for the current reporting period. only recognize it when associated expenses arise. put to unearned revenue (liabilities account)
• not easy to recognize fraud in revenue recognition
• potential red flag - AR growth faster than sales; change in how company recognize revenue
• Revenues - cost of goods sold = Gross profit. 
• COGS =  cost incurs by producing an item - material & direct labor costs. 
• significant cost for traitional maufactures, wholesalers and retilers
• use either FIFO, LIFO or average cost
• give important insights into cost trends
• increasing in cost - absorbed by company (hurting profits), passed on to consumer (might hurting sales)
• Gross Profit - Selling, general and administrative (SG&A) and other operating costs  = Operating Income
• operating expenses - selling, general, administrative, R&D, depreciation & amortization. 
• cost that cannot be traced back to specific products, it can propotionally allocated to all products.
• R&D expenses - huge expenses in healtcare & technology. Higher R&D expenses in relation to sales should have higher expectations for future growth. A firm with unsuccessful product release may not be properly spending its R&D dollars
• Depreciation - reduce cost for fixed asset. 2 methods - straight-line & accelerated
• Amortixation - decline in value of intangible assets (e.g. patents, copyright protections & other intellectual property)
• EBITDA - often used as proxy for cash flow (how much cash company can geneate?) -- company report EBITDA if they think it provides better representation of performance.
• Compare operating margin with other firms in the same industry
• Significant shifts and abnormally high or low operating margins should be scrutinized.
• Operating Income + Non-operating income - Non operating expenses = income before tax
• fiance expenses, e.g. interest expenses frin debt is a form of non operating expenses
• finance income, e.g. interest income from extra cash
• gain\loss sale of equipment, profit\loss from hedging activities
• Income before tax - tax = net proft.
• taxes can vary if there is a special situation allowing for a company to pay a
  lower tax expense or forcing it to pay a higher tax expense.
• Companies often maintain separate accounting books for investors (report high earnings while staying withint the GAAP) and tax authorities (minimize earning - minimize tax)
• Adjustment to income  - cannot fall under operating or non operating expenses e.g. extraordinary gain or loss, gain or loss on discountinued operations, non recurring items, cumulative effect of change in accounting.
• Or, to include income from associate / JV.
• Earnign Per Share
•  taking the company’s preferred dividends out of net income and dividing the result by
  the average number of shares outstanding.
•  If a company has convertible bonds or shares, stock options and warrants, diluted earnings per share must also be calculated. It represents the earnings available per common share, assuming all convertibles, warrants and options are exercised.
• Analysis
• Revenue Growth - a fundamental factor associated with strong companies
• it might be impacted by seasonal trends - comparing revenue (or profits) on a sequential quarterly growth basic can be misleading. it is important to compare with same quarter on precending year.
• pay attention to the magnitude of growth and the actual dollar amount of sales. High growth rates are hard to maintain (10% of $1 billion vs 10% of $10 billion.) - growth bigger, product markets become saturated.
• whether growth is being driven organically (growth in existing and new products sales) or through the acquisition of competitors and other businesses.
• Gross Margin
• Companies that are able to maintain high margins will attract increased competition, which can drive prices downward.
• low margin - offer "commodity products" - sensitive to changes in the prices of raw materials and labor - difficult to pass of the price increases to their customers
• Operating Expenses
• Consider why expenses have increase & whether the increases in expenses are permanent or temporary.
• If permanent, can pass to its customers & remain profitable?
• If M&A, SG&A expenses in relation to revenue should fall if change brings synergies
• EPS
• compare with analyst consensus - slight misses can send share price spiraling downward. how many analysts are following a stock? how many estiamtes are making up the consesus estimate? e.g. 1 ~ 2 analyst vs 20 or more eanlyst
• EPS growth might be misleading if there is share buy back, issues more shares, corporate exercise.. look at the shares outstanding to calculate the EPS
• net income should change in same direction and confirm what change in EPS indicate about company growth rate.
• Conclusion
• It provides insight on how firm translates its revenue into net income.
• It is important to asses the numerous expenses  that a firm incurs
• Be sure to notice trends in revenues and expenses (several years of declining can be a -ve sign)

References:-

• The Income Statement: From Net Revenue to Net Income, Z. Joe Lan