Whenever we invest in stocks, it is crucial to conduct a thorough analysis. It can be a fundamental analysis or a technical analysis.
If we use financial reports and then assess the overall financial health of a company, it is a fundamental analysis.
In a technical analysis, we use broader market data to identify trends and then make possible predictions for our investment.
I studied Bachelor of Commerce (B.Com) during my college. This course gave me the theoretical frameworks.
However, I used these principles in real life only after I started working in the fields of accounting, finance, and auditing.
This time, let’s start with the fundamental analysis – examining financial reports of a company – a statement of income.
I will also write how to read a balance sheet and a statement of cashflow in different posts.
What is a statement of income?
People also call an income statement as a Profit & Loss A/c. This shows organization’s revenue sources and expenses.
When we deduct all expenses from the total of all revenues, we arrive at the profit or loss figure of a company.
The revenue items and expense items might vary according to nature of business and industry.
But an income statement’s fundamental as a chronological accounts of the company’s performances remains the same.
Reading an Income Statement
The first item of the statement would be Gross Revenue. If the company is in trading, deducting cost of goods will give the Gross Profit.
In Bhutan, Sherza Ventures Ltd and State Trading Corporation of Bhutan Ltd have such items.
Banking and insurance companies have interest or net premium revenue. Deducting deposit interest and claims, it’s a gross profit.
It differs for manufacturing companies as well. Still the basis of arriving at Gross Profit is same for all.
The next section of an income statement is operating expenses. Selling, administration, R&D, and depreciation are recorded in this section.
We deduct sum operating expenses from the gross profit to arrive at an operating profit or loss.
We account taxes, prepaids, other income, provisions and finally get the Net Profit/Loss.
The net profit/loss is the definitive indicator of the financial standing of the company you’re planning to invest.
What to look in the statement?
We have learned how to read an income statement. It’s now a matter of connecting various items and drawing a sense.
In this regard, I use income statement ratios and check individual items which are more important.
Investors usually first look at gross margin. It shows how much revenue the company keeps after incurring associated costs.
If ABC Ltd earns gross revenue of Nu.100,000 and incur associated cost of Nu.60,000, its gross margin is Nu.40,000.
Expressed in other way – ABC Ltd can keep 40% of its gross revenue for operating needs.
Ap Warren Buffett recommends evaluating companies with gross margin above 20%. He invest in companies with 40% plus gross margin.
Just having a 40% plus gross margin doesn’t signify an optimal investing opportunity.
The 40% gross margin doesn’t matter if operating expenses are high as it won’t give substantial returns for shareholders.
We have to examine every item. Expense like R&D can be excused as it’s reinvesting in the company for future growth and earning potential.
One item we must check before the net profit is the interest expense. No one will invest in companies having so much loan.
You can then use net profit to find EPS, P/E ratio, return on shareholders’ equity etc.
Basis of Investment Decisions
This is very basic interpretation of an income statement as a part of your fundamental analysis for investing.
No matter what other investors recommend, it depends on your investing potential and risk tolerance level.
No amount of analysis can remove the risk of being wrong. However, it’s very important to build your set of convictions.
This means you must have your own well-defined set of criteria for these critical indicators as some bases of your investing decisions.
How do you use an income statement before investing in that company? Do you also look other indicators?
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