How to Analyze an Income Statement and Profitability
The income statement reports revenues, expenses and gross profit over a particular accounting period (a fiscal year, for example). It's one of the four financial statements that must be prepared by most corporations. In addition to the balance sheet, the cash flow statement and the statement of changes in shareholders' equity, the income statement provides a means of measuring a company's financial health.
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Instructions
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Determine the company's accounting method by comparing its net income with its net cash flow (found on its cash flow statement). If these two numbers are identical, the company almost certainly uses cash basis accounting. If they're different, it uses accrual basis accounting. Enough flexibility is built into accrual basis accounting to allow the company to mask financial weaknesses on an income statement. Accrual basis accounting, for example, counts income when the obligation for payment arises, not when the money is actually paid.
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Compare net income with net cash flow, if the company uses accrual basis accounting (most companies do). Generally, the higher net earnings are compared to net cash flow, the worse the company's financial health. It's normal, however, for a start-up company to have a high net income and low or even negative net cash flow, because start-ups often have to make heavy investments in equipment during their first few years of operation. For an established company, however, high income with low or negative cash flow might indicate hidden problems, such as difficulty collecting accounts receivable.
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Divide expenses by total revenue and multiply by 100. This will give you expenses as a percentage of total revenue. Perform similar calculations for the company's income statements for the preceding two years. Determine whether the company's expenses as a percentage of revenue over the last three years have been increasing or decreasing. A sharp increase could indicate revenue problems even if revenues have been increasing.
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Perform the preceding three analyses on the company's major competitors, to see how the company is performing compared to its competitors. An apparently strong financial performance might not be grounds for optimism if the company's competitors are performing even better. You can access the financial statements of publicly traded companies on the website of the Securities and Exchange Commission. Services such as Dun & Bradstreet sell access to financial data on companies that are not publicly traded.
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Subtract the cost of goods sold from total revenue, and divide the result by total revenue. This will give you gross profit margin, a measure of how much money the company is making from the sale of its products. A low number might indicate the need for high research and development expenditure in future years, to improve the competitiveness of the company's products. Average gross profit margins vary from industry to industry. Some products, for example, are expensive to produce, resulting in a relatively high cost of goods sold and a relatively low gross profit margin.
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Divide net income by revenue. This will give you the company's net profit margin, a measure of how much money the company is making with each dollar of revenue. A low number might indicate inefficient operations. Average net profit margins vary from industry to industry, however. Some industries, for example, require constant investment in expensive equipment, which increases expenditures and thereby decreases net income.
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Tips & Warnings
Analyzing all four of the company's financial statements will likely result in a more nuanced view of the company's financial health.
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