Author: Christopher Mallon

Article:
In today's article, we'll be looking at the income statement,
which is the most deceptively simple of the major financial
statements. I say simple because it's just a list of all the
revenue, minus all the expenses, to calculate what's left over
in profit. It's no more difficult than putting your family
budget together, right?

That's where the deceptive part of the description comes in.
The items on the income statement are easily manipulated by,
say, less-than-honest management, and don't necessarily
represent the true situation at a company. Even totally honest
companies can have income statements that don't represent
economic reality. Cash flows define economic reality, revenue
and expenses define accounting reality.

You see, the difference between your household budget and a
company's income statement is their relationships to actual cash
flows. Your household budget will generally match your cash
inflows and outflows. Not so with an income statement. Income
statements can vary significantly from the company's cash flow,
meaning that a company in economic trouble can show a very
" good" income statement up until the day it goes bankrupt.

Generally speaking, though, the income statement is a good
place to start when evaluating a company. In my forthcoming
e-book, Fundamentals of Financial Statement Analysis, I lay out
the process for evaluating the health of a company through the
financial statements. I'm shooting for publication in the
beginning of 2004, but in the meantime, here are some tips and
strategies for evaluating an income statement.

1. Create a Common Size Statement

What's a common size statement, you ask? It's the income
statement, only with each line item represented as a percentage
of sales. This is easy to do with a spreadsheet on your
computer, but you can do it on paper just as well. Net Sales is
always 100% at the top, and each of the expenses is divided by
total sales to arrive at a percentage. For example, if a company
has $100 in sales and $50 in cost of goods sold, the common size
statement will look like this:

Sales 100% Cost of Goods Sold 50% Gross Profit 50%

The importance of the common size statement can't be overstated.
It gives you the calculation of all your profit margins, from
gross to net, and shows how much each cost item takes away from
your profits.

2. Create a Year-to-Year Comparison Statement

The next step is to make a year-to-year comparison statement.
You can't evaluate financial statements for just a single year;
they have to be compared to previous years. The only formula you
need to know for these calculations is:

(current year / previous year) - 1 = % change

Again, a spreadsheet makes this process so much easier, but it
can be done by hand. I like to have five years of data, which
yields four years of comparison data. This way you aren't just
looking at an exceptionally good or bad year for the analysis.
Plus, you can get a reasonable estimate of future growth when
you do your discounted cash flow analysis. (I'll have more on
the Discounted Cash Flow in the future.)

3. Read the Management Discussion and Analysis

If you take the time to read the MD&A, you'll have an advantage
on most investors. A majority of individual investors simply
skip this part, and go right to calculating ratios or looking at
the EPS. Seasoned investors know that the MD&A provides the
backup data for the income statement line items, and they will
take time to read it.

A good Management Discussion and Analysis will give you the
details you need to understand the items on the income
statement. You should get segmented sales data, cost drivers,
etc. in this section. If you can't make sense of the MD&A, that
should set off alarm bells in your head. If you don't find the
information you need in the MD&A, you should.

4. Look at the Notes to Consolidated Financial Statements
(Footnotes)

The footnotes tend to be more difficult to understand than the
MD&A, but you get really detailed information here. The
footnotes are where management hides the dirty laundry. And when
you've got guys making today's corporate salaries that laundry
pile can get pretty big. Here's where you'll likely find what
you couldn't in the MD&A, it's just that in the notes you may
have to do some putting of two and two together.

Take your time sifting through this section, and try to identify
the income statement items that relate to the footnotes you're
reading. You can do it the other way around, as well, and look
for the footnotes that relate to the income statement item.

If you still can't figure out what the company is doing, after
going through the MD&A and the footnotes, you may want to
consider looking at another company. This one may be too
complicated (or too devious) for your abilities. Don't feel bad
about not understanding the business, either. Even the great
Warren Buffett admits that he doesn't understand some
businesses, and he never lets his ego run away from him. If he
can't understand it, he won't invest in it. I recommend you do
the same thing.

5. Look at segmented data

I always like to look at segmented sales and profit figures to
determine which product lines, or operating businesses, are
growing sales faster than the others. This information is
usually in the MD&A. If you can, try to find the operating
profit for each business segment as well. Then look at the
profit margins for each segment of the business.

You may be surprised at the different profitability levels of
each business segment. Compare the segment with the fastest
growing sales versus the segment with the highest operating
profit. If these are the same segment, that's good news. If they
aren't, that's okay too.

You do want to watch out for companies that have the lowest
operating profit in their fastest growing segment. This could
cause a decline in the company's overall profitability as sales
grow faster than profits. For example, a segment that's growing
5% a year, but has a 10% margin, will contribute more to total
operating profit growth than a segment growing at 20% a year
with a 1% margin.

I hope you find these tips helpful. Of course, there are plenty
of other analysis tools that you can use to evaluate financial
statements. It's important that you keep looking for more and
better ways to analyze company data, because constant learning
will make you a consistently better investor.

About the author:
Chris Mallon is the editor and publisher of the Undervalued
Weekly, a free personal finance and investment newsletter,
published every Saturday.

To sign up for the Undervalued Weekly, send e-mail to
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