Thursday, 15 April 2010

Analyzing the Income Statement to Check on Company Performance

As mentioned in the last post, a lot of details on the performance of a company can be gained by analyzing the published Income Statement. The analysis is typically done by doing some computations that involve specific values shown in the Income Statement, or partly in the Income Statement and partly in the Balance Sheet (which is a list of assets, liabilities and shareholder funds as at the end of the period).

Let us illustrate by doing some analysis on the Income Statement we had included in the last post. Click here  to open the statement in a separate window.

Profit Margins: There are three main types of "profits" in the statement viz. Gross Profit, Operating Profit and Net Profit. Each of these signify different performance issues.

Gross Profit Margin = Gross Profit / Total Revenue - 3208 / 7829 (for 2010) = 0.4098 or 40.98%. For the previous year, GP Margin was 39.86, indicating that there was some improvement in the margin. This margin generally indicates the real "margin" that the company earns over direct costs, and tends to remain comparatively stable so long as the company is engaged in the same business. Comparison of the GP margins of competing companies in the same business can reveal which of them is most successful in marketing effectiveness and/or controlling input costs.

Operating Profit Margin = Operating Profit / Total Revenue - 981 / 7829 (for 2010) = 0.1253 or 12.53%. For the previous year, OP Margin was 9.35%. Operating expenses tend to be fixed in most cases and do not vary with the levels of revenue. Hence any increase in revenue, or the GP margin, can have a disproportionately beneficial impact on Operating Profit, as has happened in this case. OP margins can also indicate the company's performance in controlling general operating costs.

Net Profit Margin = Net Profit / Total Revenue - 595 / 7829 (for 2010) = 0.0760 or 7.60%. For the previous year, NP Margin was 5.77%. Net Profit can be affected by tax rates and adjustments, and is not as indicative of company performance and GP and OP margins.

Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense - The interest coverage ratio indicates how adequate the company's earnings are to pay interest on the moneys it has borrowed. If the income is inadequate to meet even the interest payments, the company is likely to default on the principal repayment, and land in serious trouble. In the example income statement, the company has not borrowed moneys and there is no interest payment.

Returns on Funds: Return on Assets (ROA) = Net Income / Average Total Assets Employed - The value of assets is not available in the Income Statement, and has to be obtained from the Balance Sheet. Average assets employed is computed by adding total assets at beginning of the period to total assets at end of the period and dividing by two. In the example case, opening total assets as per the company's Balance Sheet was 4269 and ending total was 5152. Average assets employed is thus (4269 + 5152) / 2 = 4710.50. Return on Assets = 595.50 / 4710.50 = 0.1264 or 12.64%.

There is no "good" rate of return on assets that is universally applicable. In heavy industries where the value of assets employed are typically huge, the ROA tend to be less while for service industries, where assets employed are smaller in value, ROA can be quite high. To make the ROA rate meaningful, you have to compare it with ROAs in similar businesses in the same industry.

Return on Equity (ROE) = Net Profit / Average Shareholder Equity during the period - Shareholders' equity consists of the original money brought in by shareholders plus the accumulated earnings of the company that have not been paid out as dividends. Like assets, equity amount is also available only in the Balance Sheet, and average equity is computed by totaling opening and ending equity and dividing the total by two. In the example, the Balance Sheet shows opening equity at 3000 and closing value at 3653, resulting in an average of 3326.50. Return on Equity = 595.50 / 3326.50 = 0.1790 or 17.90%.

ROE also becomes meaningful only when compared to similar businesses in the same industry. ROE can also be compared to ruling rate of interest in the market. If ROE is less than ruling interest, shareholders might have been better off investing in bonds.

The analysis as above can thus reveal the company's performance regarding:

  • Earning profit margins comparable to other businesses in the same industry
  • Earning enough to service its borrowings by paying interest and principal installments in time
  • Employing its assets in a manner that yields good returns and
  • Providing good returns on the investment of shareholders

1 comment:

  1. This is interesting. I do find this idea very fresh and useful too.