Of the financial statements used when doing fundamental analysis for market research, the Income Statement probably rates as the most important. It is this statement that gives a detailed accounting of how much money was made and how it was spent for a given quarter or year. A variety of accounts can be found on the typical income statement, some of which vary from industry to industry. For example, a coffee company probably won’t spend much in terms of research and development (unless they are promoting bio-engineering), but a computer company will. Other examples abound.
The two most important items on the income statement are the top-line (usually called Sales or Total Revenues), and the (almost) bottom-line (usually called Net Income or Earnings). Sales essentially measure the sum total of everything the company sold. Net Income lists the amount of money left from Sales after all costs and taxes are taken away; it tells you how much the company actually pockets. So if a company lists $100,000 in sales, and has a net income of $10,000, they are making a dime off of every dollar in sales. The remaining 90 cents of every dollar is going to such things as overhead and taxes. Obviously, as an investor you like to see strong sales… but don’t get myopic. A company could have $ 3 billion in sales, yet not be profitable. It is net income that determines whether a company is profitable or not, and if it is, how profitable. To help measure this, the concept of the margin was developed. A margin is simply another way of saying “ratio” or “percent.” Specifically, net margin is simply the percentage ratio of net income against sales. That is, net margin = (net income/ total sales) X 100. In the case above, the company in question has a healthy margin of 10%.
For those who wish to dig a little deeper, there are several other items of interest on the Income Statement. The first is gross profit. This is simply total sales – cost of goods sold. Again, one wants to see this number as high as possible. And again, one can measure it as a percentage of total sales called gross margin. So, if our imaginary company above was able to produce its wares for a mere $40,000, its gross profit would be $60,000 giving it a gross margin of 60%. Next is operating income, which is essentially gross profit – operating expenses (overhead and what have you). And operating margin is operating income expressed as a percent of Total Revenues. Those three profit margins help describe the health of the operations of the business and are the three most important takeaways from any analysis of an income statement. Other items can also be found and studied, like SG&A (sales, general, and administrative), R&D (research and development), various taxes, and EPS (earnings per share). Of these, the one most commonly cited is EPS as it is the one that is most closely related to net income. In fact, it is simply net income divided by the total number of shares outstanding (that is, shares publicly owned in the marketplace). So, if our make-believe company has $10,000 for net income and 40,000 shares outstanding, it will have an EPS of $ 0.25. In other words, the company earned a quarter for every share. That does not mean that the owners of those shares will see that money. No, most likely the money will be reinvested into the company excepting that amount (if any) that is paid out in dividends. But that is a discussion beyond the scope of this article.
Note, the above discussion is meant only to serve as a primer for a conversation with a financial adviser, not to replace one.