Income Statement for Stock Investors: Sales and Expenses
Two of the most important pieces of information you should know about a company before you invest in their stock are sales and expenses. You can find both of these pieces of information on the company’s income statement.
An important piece of information to consider as a stock investor, sales refers to the money that a company receives as customers buy its goods and/or services. It’s a simple item on the income statement and a useful number to look at. Analyzing a business by looking at its sales is called top line analysis.
As an investor, you should take into consideration the following points about sales:
Sales should be increasing. A healthy, growing company has growing sales. They should grow at least 10 percent from the prior year, and you should look at the most recent three years.
Core sales (sales of those products or services that the company specializes in) should be increasing. Frequently, the sales figure has a lot of stuff lumped into it. Maybe the company sells widgets, but the core sales shouldn’t include other things, such as the sale of a building or other unusual items.
Isolate the firm’s primary offerings and ask whether these sales are growing at a reasonable rate (such as 10 percent).
Does the company have odd items or odd ways of calculating sales? In the late 1990s, many companies boosted their sales by aggressively offering affordable financing with easy repayment terms.
Say you find out that Suspicious Sales Inc. (SSI) had annual sales of $50 million, reflecting a 25 percent increase from the year before. Looks great! But what if you find out that $20 million of that sales number comes from sales made on credit that the company extended to buyers?
Some companies that use this approach later have to write off losses as uncollectable debt because the customers ultimately can’t pay for the goods.
If you want to get a good clue as to whether a company is artificially boosting sales, check its accounts receivable (listed in the asset section of its balance sheet). Accounts receivable refers to money that is owed to the company for goods that customers have purchased on credit.
If you find out that sales went up by $10 million but accounts receivable went up by $20 million, something just isn’t right. That may be a sign that the financing terms were too easy, and the company may have a problem collecting payment (especially in a recession).
How much a company spends has a direct relationship to its profitability. If spending isn’t controlled or held at a sustainable level, it may spell trouble for the business.
When you look at a company’s expense items, consider the following:
Compare expense items to the prior period. Are expenses higher than, lower than, or about the same as those from the prior period? If the difference is significant, you should see commensurate benefits elsewhere. In other words, if overall expenses are 10 percent higher compared to the prior period, are sales at least 10 percent more during the same period?
Are some expenses too high? Look at the individual expense items. Are they significantly higher than the year before? If so, why?
Have any unusual items been expensed? An unusual expense isn’t necessarily a negative. Expenses may be higher than usual if a company writes off uncollectable accounts receivable as a bad debt expense. Doing so inflates the total expenses and subsequently results in lower earnings. Pay attention to nonrecurring charges that show up on the income statement and determine whether they make sense.