A Basic Guide To The Income Statement

Foreword from ShareInvestor

This article “A Basic Guide To The Income Statement” by Cai Haoxiang was first published in The Business Times on 18 Mar 2013 and is reproduced in this blog in its entirety.

Also known as the profit and loss statement, this helps you evaluate how a company is doing and if it is an attractive investment prospect, by CAI HAOXIANG

FINANCIAL statements can be intimidating when first encountered. Rows and rows of numbers and plenty of confusing jargon greet novice investors unfamiliar with business operations.

But learning how to read, understand and analyse them is critical if one is to understand how a business operates – and decide whether a company is a good investment.

Financial statements are a report card on the business. They allow investors to get the latest snapshot of how a company is performing.

Many companies listed on the Singapore Exchange (SGX) report their results quarterly. Every three months, these reports appear on the SGX website’s “Company Disclosure” section.

Financial statements comprise three main items: the income statement, the balance sheet and the cash flow statement.

This week, we examine the income statement and offer some basic ideas on how to use it to evaluate a company.

Is The Company Making Money?

The income statement is usually the first accounting record one sees. This is also known as the “profit and loss statement”.

A key metric to look out for is net profit, otherwise known as net income or net earnings. Net profit is also known as the “bottom line” because it usually appears as the last line of an income statement.

This figure attracts a lot of attention – some say too much. If the reported figure beats what stock analysts had expected and estimated it to be, the company’s stock price usually rises. If it falls far short of estimates, the company’s stock price usually drops.

What is net profit? Net profit is how much the company has left over after tallying the money it made from selling its products, otherwise known as “revenue”, adding other income such as money made from investments, and then deducting expenses like material costs, staff salaries and taxes. A simple equation to help is: Net profit = Revenue + Other income – Costs.

Why is net profit called “net” profit? As US market regulator, the Securities and Exchange Commission (SEC), explains on its website’s “Beginner’s Guide to Financial Statements”: “It’s called ‘net’ because if you can imagine a net, these revenues are left in the net after the deductions for returns and allowances have come out.”

Let’s use a real-life example from local bakery, restaurant and food court operator BreadTalk Group. This is a company listed on the SGX since 2003.

To get its financial statements, go to “Company Disclosure” on the SGX webpage, select “BreadTalk Group Limited”, set announcement period as “Last 3 Months”, and click on announcement 88 on Feb 26, 2013: “Full Year Results/Financial Statement and Related Announcement”.

The PDF document attached, “BTG_SGXNET_FY2012”, will show the statements.

Net profit is found near the middle of the first page, located before “Other comprehensive income”.

There is a line after “profit after tax” which reports what is attributable to “shareholders of the company” and “non-controlling interests”.

Here we are not interested in profit after tax attributable to non-controlling interests, or minority interests. These represent the portion of BreadTalk’s profits that is due to other investors in the subsidiaries it owns.

We are also not interested in “other comprehensive income” as that includes measures that can distort the day-to-day earnings of the business.

For now, we will examine profit attributable to shareholders. Newspaper articles typically call this net profit.

There are six columns of numbers here. Three refer to BreadTalk’s “4Q 2012” versus “4Q 2011” results, and the percentage increase or decrease between both. The other three refer to BreadTalk’s “FY2012” versus “FY2011” results.

We see that BreadTalk’s “4Q 2012” net profit was $4.19 million, up 6.4 per cent from $3.94 million in “4Q 2011”.

“4Q 2012” refers to the fourth quarter of 2012. As BreadTalk’s financial year ends on Dec 31, the fourth quarter refers to the months October to December. Comparisons are usually made between the same period one year and the same period a year ago.

This is to ensure that the comparisons are not distorted by seasonal effects. For example, airlines usually see higher revenue in the last three months of the year as people travel abroad for their holidays.

Fourth-quarter revenue for airlines can thus usually be higher than third-quarter revenue. To see whether the company is doing better over the years, it makes more sense to compare between the fourth quarters of different years.

Profit Is Up, So What?

In BreadTalk’s case, fourth-quarter 2012 net profit increased from the same period the previous year. For the entire year of 2012, or “FY2012”, net profit was $12 million, up 3.5 per cent from $11.6 million in 2011.

Sounds good. But rising profit does not mean much unless it is placed in context. What exactly is creating these profits? And can the profits be sustained?

Here we need to introduce another important metric on the income statement: revenue, otherwise known as sales or turnover. As it is the first thing on the income statement, it is referred to as the “top line”.

Revenue refers to money brought in from ordinary activities of a business. For example, an ordinary activity of BreadTalk is to sell bread.

If it only has one product, pork floss buns, and sold a million such buns in the whole of 2012 while charging $1.50 per bun, its revenue in 2012 would be $1.5 million.

People often get confused between revenue and profit. Think of profit as a part of revenue. It is what is left over after costs are deducted. Revenue is a broader measure that tends to be the biggest number on the income statement.

Revenue is critical to the viability of a business. If a company’s products stop selling well and it is forced to lower prices, revenue will drop and along with it, net profit.

Conversely, improvements in revenue will usually bring about increases in net profit if costs are managed well.

For BreadTalk, its full-year revenue in 2012 was $447.3 million, up 22.3 per cent from $365.9 million in 2011. Its net profit for the year, however, increased by just 3.5 per cent.

Higher revenues do not always translate into proportionally higher net profits.

The Cost Bugbear

The reason is higher costs. BreadTalk and many other food-and-beverage operators in Singapore have been grappling with rising materials and rental costs, and a tighter labour market that pushed up staff salaries.

Take a look at the second line of the income statement, “cost of sales”, and the sixth and seventh lines, “distribution and selling expenses”, and “administrative expenses”.

Cost of sales, otherwise known as cost of goods sold, includes the cost of raw materials used to make a product. For BreadTalk, this might include the cost of flour used to make bread.

Distribution and selling expenses include costs associated with delivering a finished product from a factory to a retail store, storage costs, as well as advertisement and marketing costs like promotion activities and salaries of sales staff. Administrative expenses include salaries of office staff and senior executives, rent, stationery and postage costs.

For BreadTalk, cost of sales increased $40 million in 2012. Distribution and selling expenses increased $35 million while administrative expenses rose $7.7 million.

Added together, these three costs cancelled out BreadTalk’s revenue increase of $81.4 million in 2012. They eroded away what would otherwise have been net profit.

As a result, net profit was nudged up by just $408,000 after joint venture results and tax were taken into consideration.

Cutting costs while keeping revenues up are essential to better business performance.

Profit Margins

One way to measure that performance is through a financial ratio known as the profit margin. This is calculated by taking a profit measure and dividing it by revenue.

Profit margins represent how efficient a company is at making money.

For example, a company might report revenues of $100 million a year but net profit of just $1 million. Another might report similar revenues but $10 million of net profit.

All things being equal, the second company is a more attractive investment proposition than the first.

On BreadTalk’s income statement, the third line, “gross profit”, is a rough measure of how much the company made relative to its revenues after basic costs were deducted. Divide gross profit by revenue in 2012, and you get what is called a “gross profit margin” of 54 per cent. This is a slight dip from BreadTalk’s gross profit margin of 54.7 per cent in 2011, indicating rising costs.

Go back further, and one finds out that BreadTalk’s gross profit margin of 54 per cent last year is its lowest in at least five years, down from a high of 55.4 per cent in 2007.

Falling margins are not necessarily bad if they spur BreadTalk to use technology and productivity improvements to boost its bottom line. But if its competitors can manage their costs more effectively, BreadTalk shares will not be as attractive.

In future articles, we will discuss other accounting statements such as the balance sheet and cash flow statement.

The investor ultimately needs to be able to use them to understand how a business works.

Only then can an estimate of the value of the business be made, and a decision taken on whether to invest in the company.