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Analyzing Financial Statements – The Income Statement

The previous post had looked at some metrics that could be derived from the balance sheet of a company. This week, we will look at other metrics that could be computed using the consolidated earnings statement of a company.

Consolidated Earnings Statement (Income Statement)

A statement of earnings provides information about a company’s revenue and its net income after expenses, interest, and taxes in any quarter or year. This statement is a report card about the financial health of the company and it provides good insight into the profitability of the company. Several ratios can be calculated from a statement of earnings.

Operating Profit Margin

This is a ratio of the operating income (i.e., income after expenses) to the revenue generated by the company.

Operating Profit Margin (%) = (Operating Income / Revenue) * 100

The operating profit margin varies based on the industry the company is involved in. A health care company will obviously have an operating profit that is different from a utilities company.

Net Profit Margin

This is a ratio of the net income (i.e., income after expenses, interest, and taxes) in relation to the revenue generated.

Net Profit Margin (%) = (Net Income / Revenue) * 100

Again, testing the standing of a company based on its net profit will have to be done by comparing it to peers from the same industry.

Return on Assets

This metric is computed by dividing the net income by the average (of two years) total assets (in other words, the average of the total assets at the beginning and the end of the current fiscal year). The total assets can be found on the balance sheet.

Return on Assets (%) = (Net Income / Average Total Assets) * 100

The average total assets are used to determine the company’s ability to efficiently use its assets to provide a return to shareholders.

Return on Equity

The return on equity for a company is calculated as a ratio of the net income to the average (of two years) shareholders’ equity (in other words, the average of the shareholders’ equity at the beginning and end of the fiscal period). The shareholders’ equity will be listed on the balance sheet.

Return on Equity (%) = (Net Income / Average Shareholders’ Equity) * 100

It should be noted that shareholders’ equity does not include preferred shares.

Interest Coverage Ratio

As the name suggests, this ratio determines the ability of a company to meet its interest payment obligations.

Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

The higher the interest coverage ratio, the better the position of the company to meet its interest expense requirements.

Price to Sales Ratio

This ratio computes the value of shares with respect to the total sales achieved during the fiscal year.

Price to Sales Ratio = Share Price / (Revenue / Diluted Number of Outstanding Common Shares)

The lower the price to sales ratio, the better. But, this metric will differ depending on the industry in question.

Cash Conversion Cycle

This metric calculates the number of days a company takes to convert its input to output, i.e., resource into cash. The cash conversion cycle considers the time the company takes to sell its products, collect its dues, and pay its bills without any interest.

Cash Conversion Cycle = Outstanding Inventory (in days) + Outstanding Receivables (in days) – Outstanding Payables (in days) where,

Outstanding Inventory (in days) = Average Inventory / (Cost of Sales / 365)
Outstanding Receivables (in days) = Average Receivables / (Revenue / 365)
Outstanding Payables (in days) = Average Payables / (Cost of Sales / 365)

The average inventory, average receivables, and average payables are derived by computing the average of the data at the beginning and end of the fiscal period in question. Cost of sales can be found on the earnings statement.

This metric is mainly useful for retail companies such as Walmart and Target, where lesser days to convert cash is better for the business.

Have you used the above metrics as part of your stock research? Do you buystocks based solely on numbers, i.e., without considering current market or other factors?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.

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About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 1 comment… add one }
  • Jean September 17, 2011, 9:53 pm

    Definitely have used alot of these ratios in my finance courses that I took. I dont buy stocks solely based on the numbers, but more or less the overall picture. Certainly the numbers are a driving force behind my decision but the current market conditions, and future indicators are the final piece of the puzzle in my decision.

    -Jean

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