How to analyze company’s profitability by using income statement

By buying stocks, you are claiming a piece of the company’s earnings or profit. As a fundamental analyst, your first thing is to evaluate following things to know how well the company has done financially:

  • How much money it brought in, and
  • how much it spent to operate, and
  • Amount of profit it generated.

If you have evaluated and invested right, then the company will multiply its earnings and your stake will become more valuable.

To find out right company to invest, you need to analyse company’s income statement and project its future earnings based on management guidance and projected growth in earnings.

Below are the main components of a income statement:

  • Revenue – money brought by selling goods and services
  • Cost of goods sold – money spent to create the goods and services sold. It’s the direct costs incurred to make money.
  • Operating expenses – all indirect costs (not directly related to the product or services) incurred for doing business. Marketing, selling and administrative expenses are considered as operating expenses.
  • Other income – money brought by the company for things other than by selling products and services
  • Earning before interest and taxes
  • Interest expenses –  residual amount left out after you deduct cost of goods sold, operating expenses from total revenue.
  • Taxes – company pay taxes on the net earnings arrived as per income tax act. Accounting net earnings may differ from tax net profit for various reasons.
  • Net earnings – this is the amount company earned during the year after incurring all expenses. It’s also known as bottom-line in income statements.

To analyze profitability, you need to use financial ratios by comparing earnings with other components. By doing so, you will be able to assess how well company is managing its expenses.

Below is a list of important financial ratios to analyze company’s profitability by using income statements:

Gross profit margin

Gross profit margin is calculated as a percentage to total revenue to measure how much money the company makes after paying all direct costs (cost of goods sold) connected to the product or services. You can calculate gross profit margin ratio by following below steps:

  • Calculate gross margin of the company by subtracting cost of goods sold (cost directly connected to producing the product) out of revenue.
  • Divide gross profit margin by its total revenue and multiply it by 100.

In other words, this ratio will let you know the percentage of revenue company is able to retain after paying all direct costs related to producing a product. This means, gross profit margin gives you the first indication of how much the company is left to cover its overhead and other indirect costs.

Gross profit margin can be affected due to changes in sales volume, sales price, and cost of productions.

If the company has a higher gross profit margin, then it has a very good cost management tool or operating at a higher margin, may be because of limited supply or high demand of its products. It indicates that by managing company’s overhead costs, business can make very good profit.

Operating margin

Financial analyst calculate operating profit margin to know how much money the company keeps after paying direct and indirect costs. It will tell you how profitable the company was for the period in its core business and how good the company is at controlling the costs and expenses of its operations.

Operating revenues minus operating expenses results in operating income. Sometimes, operating income is referred as EBIT, earnings before interest and taxes. The remaining deductions from EBIT is interest and taxes.

Here are easy steps to calculate operating profit margin of a company:

  • Calculate operating profit by subtracting both direct and indirect costs from total revenue.
  • Now divide the operating profit by revenue and multiply it by 100.

Operating profit margin = (EBIT / Sales)*100

Higher profit margin indicates that the company has more pricing flexibility,a good cost management mechanism and is a safe bet during tough economic times.

Net profit margin

Net profit or earnings is the most important thing that investors will be interested to know at every earnings release.

Net profit is the amount left out after taking all the costs of a company from its total sales/revenue. Higher net profit margin indicates that the company is very good at converting revenue into earnings and have a very good cost control mechanism. Net earnings of a company is calculated by taking out interest and taxes from EBIT.

Net profit of a company reflects company’s ability to deliver goods and services at a price in excess of the costs. It tells you the money company kept for the period after paying all costs and expenses. Analyst always forecast future profitability by analyzing past performance of the company.

You calculate net profit margin to find out the percentage of money on revenue the company keeps after paying all costs and expenses. To calculate, you need to follow below steps:

  • Calculate net profit by subtracting all costs and expenses from revenue.
  • Divide net profit by revenue and multiply it by 100.

Above three important ratios will tell you how the company has made profit in comparison to its total revenue.

In addition to profit margin ratios, you can also calculate earnings per share, price to earnings ratio, return on equity and PEG ratio to analyze earnings better.

Please note, the income statement is prepared based on accrual basis accounting. This means it contains financial information about the economic activity that did not necessarily result in a cash flow. In addition to income statements, you must see statement of cash flow to know exact cash position of the company.

In addition to profitability, you should also assess company’s liquidity ratios to know about company’s ability to meet its short term obligations.