| How to analyze your chosen firm income statement?
We are using a hypothetical income statement to demonstrate income statement analysis:
| Fiscal Year Results |
| (in thousands of U.S. dollars) |
Year 1 |
Year 2 |
Year 3 |
| Net Sales |
340,000 |
360,000 |
425,000 |
| Cost of Goods Sold |
162,000 |
167,000 |
195,000 |
| Gross Profit |
178,000 |
193,000 |
230,000 |
| Gross Profit Margin |
52.35% |
53.61% |
54.12% |
- Revenue (net sales) increased 5.88% in the second year and 18.06% in the third year. An increasing growth rate in revenue is good, especially if the sources of revenue are strong and have good long-term prospects.
- Cost of goods sold increased by 3.09% and 16.77% in the second and third years, respectively. Note that the cost of goods sold increased less than revenue; because of this, gross operating margin increased from 52.35% in the first year to 54.12% in the third year. Gross operating margin is found by dividing gross operating income (revenue – cost of goods sold) by revenue.
| Depreciation |
29,000 |
33,000 |
42,000 |
| Selling Expenses |
52,000 |
55,000 |
63,000 |
| General and Administrative |
45,000 |
46,000 |
49,000 |
| Total Operating Expenses |
126,000 |
134,000 |
154,000 |
- Depreciation, selling expenses, and general and administrative expenses make up the operating expenses. Operating expenses increased by 6.35% and 14.93% in Years 2 and 3 respectively, as follows:
| Operating Income |
52,000 |
59,000 |
76,000 |
| Operating Profit Margin |
15.29% |
16.39% |
17.88% |
|
| Interest Expense |
12,000 |
15,000 |
20,000 |
| Income Before Taxes |
40,000 |
44,000 |
56,000 |
| Income Taxes |
13,000 |
14,000 |
15,000 |
|
| Net Income |
27,000 |
30,000 |
41,000 |
| Net Profit Margin |
7.94% |
8.33% |
9.65% |
- Operating income is gross profit – operating expenses. Operating income increased 13.4% and 28.81% in Years 2 and 3 respectively, both of which are faster than revenue growth. When operating income is growing faster than revenue growth, operating profit margin will increase, which is what happened in this example. Operating profit margin increased from 15.29% in the first year to 17.88% in the third year.
- Subtracting interest expense and income taxes from operating income results in net income. Increasing net income is an important goal for most companies. In this example, net income increased by 11.11% and 36.67%.
- Net income increased faster than revenue growth, so net income margin increased. Net income margin is found by dividing net income by revenue.
How to analyze a balance sheet:
The balance sheet shown can illustrate how financial analysts evaluate balance sheets:
| (in thousands of U.S. dollars) |
Period Ending Dec. 31, 2012 |
Period Ending Dec. 31, 2013 |
% Change |
| Assets |
|
| Cash and Cash Equivalents |
9,100 |
9,900 |
8.79% |
| Accounts Receivable |
8,250 |
8,700 |
5.45% |
| Inventories |
55,000 |
60,000 |
9.09% |
| Prepaid Expenses |
8,500 |
8,950 |
5.29% |
| Deferred Income Taxes |
7,000 |
7,300 |
4.29% |
| Total Current Assets |
87,850 |
94,850 |
7.97% |
|
| Property, Plant, & Equipment |
85,000 |
90,000 |
5.88% |
| Intangible Assets |
25,000 |
36,500 |
6.00% |
| Total Assets |
197,850 |
211,350 |
6.82% |
- Current assets increased by 7.97%, driven by a 9.09% increase in inventories. This could be a positive or negative, depending on the reason for increased inventory. If sales were increasing rapidly and the company had to replenish inventory to keep pace with sales, then this would be viewed as positive. On the other hand, if sales were flat or declining and inventory was increasing, then the firm would be buying goods that would take a longer time to sell, tying up cash in inventory that could be used for something else.
- Total assets increased by 6.82%, with a $5 million increase in property plant and equipment. This could be caused by increased sales and the company’s expansion of its production capabilities.
| Liabilities and Equity |
|
| Current Portion of Long-Term Debt |
1,500 |
1,600 |
6.67% |
| Accounts Payable |
35,000 |
37,000 |
5.71% |
| Other Current Liabilities |
8,000 |
8,550 |
6.88% |
| Total Current Liabilities |
44,500 |
47,150 |
5.96% |
|
|
|
|
| Long-Term Debt |
45,000 |
47,500 |
5.56% |
| Other Long-Term Liabilities |
5,000 |
5,200 |
4.00% |
| Total Liabilities |
94,500 |
99,850 |
5.66% |
|
|
|
|
| Equity |
103,350 |
111,500 |
7.89% |
- The increase in accounts payable is the major driver of the increase in short-term liabilities. This could be related to increased sales and, therefore, the increase in the amount owed to vendors.
- The increase in total liabilities was largely derived from the increase in long-term debt. This is likely related to increased property, plant, and equipment (meaning that the company may have used long-term debt to finance the production expansion).
- Shareholder’s equity increased by $8 million, or roughly 8%. Because assets increased by $13.5 million and liabilities increased by only $5.35 million, shareholder’s equity increased by the difference, or $8.15 million. It is difficult to judge this value without considering net income because financial analysts look at the return on equity (net income / equity) to determine the meaning of the equity value (in addition to how it was derived)
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