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Fundamental Analysis: The Income Statement

Saturday, February 13, 2010

Every trading day would see me looking at charts in the evening and looking out for pertinent news which might have an impact on my investments.  On weekends, I would sometimes blog about my personal experience and some ideas which I might have about investments.  The Chinese New Year long weekend is giving all of us a much needed break from trading. Take some time to smell the flowers, so to speak.

I have decided that I will blog about different aspects of FA and this will probably spread over a few posts to make it more manageable.  My formal education in Economics and Business Administration, specifically, Financial Management help to inform my FA.  Of course, these are textbook material and I try to keep myself up to date by reading weekly periodicals such as Newsweek and The EDGE.  I also read analysts' reports, not to blindly follow buy or sell calls but more as an idea generating exercise.  Being in business development also gives me an inside feel of the business climate especially in South East Asia where the company I work for has the greatest exposure.

In an earlier post, I said that FA could be done on many levels but the most basic level would be looking at a company's financial numbers.  I have learnt much to my own regret that to overlook this for any reason (usually due to complacency) could be a big mistake.

What is an Income Statement?  This basically tells us how a company's operations performed over a period of time.  Right at the top is the gross revenue (GR) the company has generated.  In a company that deals with goods, you will have to deduct the cost of goods to arrive at the gross profit or GP.  For people who are in tune with Warren Buffet's investment philosophy, you would remember that he says we should always look for companies with GPs of no less than 20%.  In fact, he consistently targets companies with GPs of 40% or higher.

So, let us say that a company has a gross revenue of S$100,000 and their cost of goods is S$60,000.  Gross profit is S$40,000.  As a percentage, the GP is S$40,000(GP)/S$100,000(GR) = 40%.  Simple enough.

Does this mean that everytime we see businesses which generate a GP of 40% or more, it is a good buy?  No, we continue by looking at the next part of the Income Statement which shows the operating expenses.  These are the Selling, General and Administration expenses or what is referred to as SGA, the Research and Development (R&D) expenses and Depreciation.  Upon taking out all these expenses, we arrive at the Operating Profit or Loss of the company.  As you can probably tell, a company which incurs massive expenses despite a high GP is not going to have much left for the shareholders.

The next part is the Interest Expense, Gains or Losses from sale of assets and Others.  Taking all these out give us the Income of the company before tax. 

We want to make sure that the company is not borrowing too much and not paying too much for its borrowings.  This is what is known as leverage.  There are many companies which are heavily leveraged and as long as they are making more money than the interest they are serving on their loans, they look good but if the tide turns and, in the last financial crisis, we saw how quickly they could turn, things could become very ugly.  So, imagine if revenue dries up during a recession and the interest expense remains high, not a pretty picture. 

Having said this, leveraging is not all bad.  Credit is said to be the lifeblood of businesses.  Few businesses in this world operate with zero leveraging.  As long as it is kept at a level that is manageable, a level that will not threaten the viability of the company in the worst case scenario, it is acceptable.  This is what is called stress testing.

The next part of the Income Statement would be the taxes paid.  Once this is taken out, we have the net earnings of the company.

I hope you have found this post to be informative and I will blog about the Balance Sheet and Cash Flow Statement in upcoming posts.

Related posts:
Identifying trends and value: FA and TA
Determining the impact of news on specific companies.
Monitoring our stocks.



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7 comments:

Elmer Tang said...

I like this easy way to describe Income Statement as such. I learned some key performance indicator which we need to look for during our stock allocation, such as GR, Debt leverage ratio, NPBT, etc.

AK71 said...

Hi Elmer,

I am glad you like it. Do visit again soon. :)

Anonymous said...

Interestingly simple to understand. TQ

AK71 said...

Hi Anonymous,

You are welcome. :)

Could you include your name or initials in future comments? Thanks. ;)

emo only said...

Hi AK, how do you get to see the income statements for companies..?

AK71 said...

Hi Emo,

Go to their websites and download their annual reports. If you want the latest, download their quarterly reports.

emo only said...

Oh.. Thanks a lot AK!

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