Fundamental Analysis and the Income Statement
Fundamental analysis requires you to pay close attention to the income statement for any sign the company isn’t progressing as it should or, conversely, doing better than many thought it could. By buying shares of stock, you’re claiming a piece of the company’s future revenue and profits. The trick, though, is making sure the company is keeping its end of the bargain by generating a profit. That’s where the income statement comes in.
Companies that have issued stock on a stock market exchange such as the New York Stock Exchange or Nasdaq, or borrow money from the public, are required to issue an income statement. The income statement spells out in exhaustive detail how the company did during each quarter and year.
No two income statements look identical, and subtle differences can make comparing one company’s income statement with other companies’ problematic (you can read about making comparisons more in Chapter 16). Income statements can also vary a bit depending on what line of business a company is in. Luckily for investors, the accountants have somewhat standardized the way companies must prepare the income statement. Income statements tend to follow the same basic structure.
You can dedicate a great deal of time obsessing over every nuance of financial statements, including the income statement. If that’s of interest to you, check out Reading Financial Reports For Dummies (Wiley, 2013), which gets into the nitty-gritty of financial reporting. In this book, the one you’re holding, you’ll get a look at the basic layout of the income statement and what you’ll need to do some serious fundamental analysis.
The basic structure of an income statement includes these items:
- Revenue: This is how much money the company brought in by selling goods and services. Revenue is often called the “top line.”
- Cost of goods sold: It takes money to make money. Cost of goods sold measures what a company must spend to actually create the good or service sold. These are direct costs, meaning they are costs for items that may literally go into the products. Cost of goods sold, for many manufacturing companies, is the largest single cost of doing business. For instance, with an automaker, the cost of goods sold might include the cost of steel used to build the cars.
- Operating expenses: Indirect expenses are incurred by companies as they conduct business, but may not go directly into the product. These costs are usually necessary or important, but peripheral. These indirect costs are called operating expenses or better known as overhead. Operating expenses may include:
- Marketing expenses: Include advertising and other promotional expenses.
- Research and development: What a company spends to cook up new products or services to sell to customers.
- Administrative expenses: Expenses connected with support staff, such as legal, human resources, and other functions that are directly tied to manufacturing the product.
- Other income: Companies sometimes bring in money for things other than selling products and services. This income is recorded as other income. For instance, a company might win a legal settlement or sell a factory.
- Other expenses. Just as “other income” doesn’t qualify as revenue, other expenses do not qualify as normal operating expenses. Other expenses might include the cost to restructure a unit of the company, paying severance to lay off employees, or depreciation — accounting for wear and tear (see the sidebar, “Appreciating depreciation“).
- Earnings before interest and taxes. After you subtract cost of goods sold, operating expenses, and other expenses from revenue, what you’re left with is earnings before interest and taxes.
- Interest expense. Most companies borrow money to fund their operations or to buy inventory. Here, the company discloses how much it’s paying to borrow money.
- Taxes. Companies must pay taxes too. Here, companies disclose how much they they paid to Uncle Sam.
- Net income. Finally, after paying all these costs and expenses, what’s left is the profit, or net income. This is how much the company earned during the period, based on accounting rules or GAAP.
Ever hear a company say it used GAAP? No, that doesn’t mean they used expense accounts to buy khakis and collared shirts at a popular clothing store. Instead, I’m talking about GAAP — Generally Accepted Accounting Principles — painstakingly detailed rules that instruct companies on the right way to report results.