Why We Should Analyse The Income Statement?


 Why analyze the Income statement?

The income statement answers the question, 

“How well is the company’s business performing?” Or 

 “Is it making money?” i.e.,

It summarizes how the company’s operations performed during a given period. 

  • It tells you how much money a company has brought in as revenues
  • How much it has spent (its expenses) 
  • And the difference between the two (its profit). 
  • Did the company make a profit during the current year? 
  • Did it improve its business over last year?
  • A firm must make more money than it spends or it won’t be in business for very long. 

A firm must be able to bring in more money than it spends or it won’t be in business for very long. 

Balance sheet + Income Statement = Profitability

It tells you what kind of a return does the company generates on the capital it invests? 

How much profit does the company generate relative to the amount of money invested in the business?


Components Of Income Statement:

Net Sales: This is the income which the company generates by selling its goods and services.

An applicable indirect tax (GST) has to be deducted from the Gross Sales to get the Net Sales figure

as these taxes are collected by the business for the government and don’t belong to the business. 

From an analysis perspective, it is important to understand the contribution made by different segments and markets, the cyclicality of the sales revenues, and the management’s strategy to manage any risks to sales growth, such as new products, diversification into new markets, etc. 

Growth in sales must be analyzed to determine the contribution of an increase in volume and/or increase in price.

Direct Costs: These are costs that can be attributed directly to the business. Examples of these types of costs are raw material, salary, electrical costs, and others. Reducing operating costs will translate into higher profitability. 

Lower the direct costs, the higher the operating efficiency of the firm. Costs may be variable, such as raw materials, semi-variable, such as employee costs or fixed, such as plant and machinery. 

Companies with high fixed costs can be benefited from the operating leverage. This is because an increase in sales can be made without taking on additional costs. In periods of growing sales, such companies benefit from better profit margins. 

The cost structure of the companies also exposes them to risks when business slows down.

Earnings Before Interest Tax Depreciation and Amortization (EBITDA): This is the difference between Net Sales and Direct Costs. EBIDTA is a measure of the operating efficiency of the company. 

It will help us to compare the companies that may have different capital structures, depreciation policies, and tax rates. Higher the EBITDA, better the firm.

EBITDA is calculated as (Net Sales) – (Direct Costs).

EBITDA Margin: This ratio calculates the EBITDA as a percentage of Net Sales.

Looking at absolute numbers makes it impossible to compare two firms, however, when converted into percent, comparison can be done easily. 

Higher the EBITDA Margin, better the firm.

EBITDA Margin is calculated as [(EBITDA)*100/ (Net Sales)].

Depreciation/ Amortization: Whenever a company purchases an asset, it is used for a long period of time and hence, it does not make sense to show entire expenditure at once in the P/L statement. 

As an example, to sell goods worth Rs. 100 crores, the company needs a machine that is worth Rs. 100 crores. Now, if the company were to take a loan of Rs. 100 crores and purchase the machine and show it as expense in the first year itself, three problems arise:

  1. The company immediately goes into a loss as income is Rs. 100 crores and expenditure would overshoot it.
  2. The machine would still be available for the company to use for future years but it cannot be shown as an asset.
  3. As the company would go into losses, it would not pay tax and that would result in loss of tax revenue for the Govt.

In order to prevent these anomalies from occurring, the expense of buying a machine is divided into the estimated life of the asset (machine, in this case) and each year a part of the expense is shown in the P/L statement and the remaining amount is kept with the company as an asset and is shown in the Asset portion of the balance sheet.

In our example, each year the company would show Rs. 20 crores as an expense and correspondingly reduce the Asset by that much amount, so that in 5 years the entire machine would be ‘consumed’.

Amortization is the term used for depreciation of intangible assets such as copyrights and brands. While depreciation or amortization is shown as an expense in the P/L account, there is no actual cash outflow on account of this expense each year. 

The expense has been met upfront when the asset is bought. Deducting Depreciation/ Amortization from EBITDA gives us EBIT.

EBIT is calculated as (EBITDA) – (Depreciation/Amortization)

Interest: Interest is an expense incurred on loans taken by the business. A change in the interest costs of the company can be attributed to an increase or decrease in the debt outstanding, change in interest rates or currency fluctuations in the case of foreign currency loans.

Many of the best companies in India as well as in the world have extremely low or even no debt. 

Warren Buffet’s view on the debt would help us understand with more clarity, the dangers of high debt:

“Good investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage. It seems to us both improper and foolish to risk what is important for some additional returns that are relatively unimportant.”

Other Income: This is recurring income from other sources such as rent, interest, dividend, commission, etc. It should at best be a small portion of the Net revenues of the company. If this income is quite high in comparison to sales, it warrants an analysis of the business model of the company. 

It is best to compare other income of the business over the last several years and also find if there were specific triggers for high other income in some types of businesses.

For example: In banking, there are times when interest rates are high and due to which, while on one hand, banks keep receiving deposits, on the other hand, loan off-take is relatively slow.

In such cases, banks invest in long term G-Secs and benefit from the rise in their prices when subsequently interest rates fall. In such years, other income accounts for a huge component of the total income.

Profit Before Tax (PBT): Deducting Interest and Depreciation/Amortization from EBITDA and then adding other income to it gives us the total profit of the company for the period after meeting all the expenses. Taxes need to be paid on this profit and hence it is known as PBT.

Tax: This is the money which goes to the Government. At present, the corporate tax rate in India is between 25% and 35% depending on the turnover of the company.

Profit After Tax (PAT): This is the final residual amount that remains with the company after paying all its stakeholders other than shareholders. This is the shareholder’s money and maybe paid out as a dividend or may be retained in the company partially or fully for further expansion.

Bottom line: Income statement tells you how much the company made or lost in accounting profits during a year or a quarter. Unlike, the balance sheet, which is a snapshot of the company’s financial health at a precise moment, the income statement records revenues and expenses over a set period, such as a quarter or fiscal year.