Company can’t keep all the money they brought from customer by selling products or services. A major portion goes out in paying for all direct and indirect expenses incurred to generate money. A simple cost analysis can tell you whether the company is a good investment or not.
Income statement of a company record all expenses under different heads to tell investors how they spent money to generate revenue.
You should not look only on company’s total cost or amount spent towards COGS or operating expenses. To analyse expenses of a company, you need to dig deeper into the line items of income statement.
You can find breakup of the cost of goods sold and operating expenses in notes to accounts section of the financial statements.
Company’s cost analysis can be done for following reasons:
- To a set a budget or plan for the future
- To give estimation for a particular project, tender or a particular service.
- To know the cost structure of the company
- To know how the impact of each line items of income statement on the top and bottom line of the company.
In this article, we will show three different methods to do a cost analysis before investing in stocks.
Vertical cost analysis
After getting head wise costs of the company, you need to compare each expenses to the revenue to know what percentage of the revenue has been spent towards these expenses.
To convert the number into a percentage, you need to divide each expenses of income statement by total revenue and multiple it by 100.
For instance, it cost of goods sold and revenue of a company is 65 and 100 respectively, then to you can calculate the percentage by dividing 65 by 100 and multiply it with 100 ((65/100)*100), which comes to 65%. This measures that company’s COGS is 65% of the revenue. If due to certain economic factors, costs are going up and revenue is down, then it will have a impact on the company’s bottom line.
Horizontal or trend analysis of cost
Similarly, you can do cost analysis by comparing revenue of the current quarter/year with the earlier quarters/years.
In this way, you can know which costs for the company is going up and whether the company is able to manage cost in comparison to growth in revenue. If the expenses are moving at pace with industry and company’s growth, then investing into the company can be a good idea.
You can mix vertical and horizontal analysis to study the trends better.
Financial Ratios
Horizontal and vertical analysis will help you to do line item wise comparison of costs with revenue.
You can use financial ratio analysis tools to measure company’s net profit margin, gross profit margin, operating profit margin, interest coverage ratio, price to earnings ratio (P/E), Return on equity (ROE), return on investments (ROI), earnings per share (EPS), dividend payout and other important ratios to assess liquidity, profitability and financial health of the company. It’s basically use of different tools to analyse company’s financial position.
While analysing costs incurred by the company for the period, you need to read it with reference to the notes of accounts and auditors report as it will clarify lots of points.
