How to Analyze an Income Statement

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Income Statement
Income Statement

Learning how to analyze an income statement is fundamental to smart investing. The annual income statement is the evaluation of the company’s financial dealings, and can be used to help determine if it would be a worthwhile investment.

Look at the data concerning the company’s ratios. This is the main focus of this type of evaluation. The current ratio (ratio of current assets to current liabilities) will let you see at a glance how liquid the company is (whether it can meet its obligations).

Consider a current ratio of 1.5 : 1 to be acceptable, and one of 2 : 1 can be looked on as good. Another way of looking at the current ratios involves taking the inventory out of the liability side of the equation - this is because inventory can be the least liquid of all available assets.

Look harder at the company if inventory seems excessively high, as a more in depth analysis may be needed to reveal the reason - this can be a warning sign that the company has over-reached itself or that demand for their product has dwindled.

Calculate the price/earning (P/E) ratio: if a stock is earning $2 per share and selling at a market price of $40 per share, the P/E ratio is 20. This is a good ratio for long term shares; an example of a riskier share might be one that was selling at $10 but had the potential to earn $5, which would have a much lower P/E ratio of 2.

Evaluate the risk factor and make your decision as to whether you should invest. You always want to balance your portfolio between a few high risk investments and a wide assortment of safer long term ones, and knowing what to look for when analyzing an income statement is a good way to understand where each company stands.

Tips & Warnings

  • Don't rely solely on the income statement when evaluating a company. Also look at the other financial statements such as the the cash flow statement and balance sheet to get the full picture of the company's health.

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