While a balance sheet is a snapshot of a company's financial position, the income statement shows the operating activities for an entire period.  The balance sheet tells you how financially sound a company is.  The income statement answers the all-important question: "Are they making money?" 

A stock’s price is based in large measure on how well the company is likely to perform in the future.  And the income statement provides a solid basis for forecasting future profits.  A single year’s results are not enough to do this.   Most income statements already include three years of information, so it's best to download at least two from a source like www.freeedgar.com.  For my example, if you retrieve the form 10-Ks from 2002 and 1999, you will get a full six years of data that can easily be imported into a spreadsheet.

The layout of an income statement is usually similar among different companies, but can differ according to what business they are in.  They all start out at the top with the main source of income (which could be called things like "sales" or "gross revenue").  They then list other sources of income.  Then the company begins to subtract out various itemized expenses.  At the bottom, they show their final net income (or loss) for the year.

Below is an example of the fiscal year 2003 income statement from Cisco Systems after I loaded it into Excel:

As you can see, it’s really not that complicated for a $100 billion company.  In many ways it’s not unlike a budget any typical household might put together.  You get your income and then deduct things like taxes, insurance, rent, utilities, and other living expenses.  Anything left over is called discretionary income, which you can think of as profit.  Of course, the numbers on yours are probably not measured in millions.

Another difference between your budget and a company’s income statement is that the term "income" doesn't always refer to actual cash moving in and out.  Most companies use the accrual rules of accounting, which means that a firm can record income when it sells goods or services regardless of when they actually get paid. 

You should also be aware that company expenses are recorded at the time an asset is actually used.  That means that even if a company paid $100,000 up front for an asset (a piece of machinery for example), they may write if off over a period of time, say $20,000 a year for five years. 

So the company would record only $20,000 as an expense each year instead of expensing the full $100,000 up front.  That may seem a little technical, but it is important to know since a company with positive earnings on their income statement can still go bankrupt if it doesn't have enough cash on hand to meet their day-to-day needs.

So now that we have all these numbers, what kind of fun can we have with them?  The income statement is actually good for a couple things.  First, if you have the past two years of balance sheets, you can see how changes there were accounted for, all the way up to being able to create (or double check) a company’s statement of cash flows.  Second, you can use the numbers to help you judge the soundness of the business and the direction it is heading (absent the rare cases of outright fraud, of course).    

Something that is often useful to look at is the composition of income.  Cisco breaks down net sales into product and services, with more than 80% of sales coming from the sale of actual equipment.  Services tend to offer a more stable source of income then selling products (routers and such in Cisco’s case). 

When the economy is bad, companies may not invest much additional money to expand into new businesses, or to upgrade their current equipment.  But they will continue paying for the services that keep their current business up and running.  Sales composed of 80% products means they are very exposed to the risk customers may stop buying for any reason (such as Telecom companies lately).  

Other than looking at the numbers themselves, I usually content myself with a quick look over with just some very basic calculations.  The main things I look at are:

• Earnings Growth – Are earnings (per share) steadily increasing over time?
• Profit Margin – Are profit margins increasing?  Declining margins a bad sign.
• Interest Coverage Ratio - 3 to 4 at least, although I prefer higher.
• P/E Ratio – Need to compare to industry or historical average, low is good.

Earnings Growth

The basic reason for an income statement is to show if the company made money or not.  Positive earnings (otherwise known as a profit) are very important.  It may be worthwhile to run a short-term loss if you are investing in expanding capacity, or entering a new business or market, but eventually you need costs to be less the income in the long term or you will go out of business.

Current earnings can give a good estimate of a firm's expected performance.  Corporate earnings are an important valuation parameter, since the stock price is basically the present value of the firm.  And that present value is calculated by the company’s Book Value plus the present value of future earnings.  The widespread coverage of earnings announcements in the media, and the change in stock prices after their release shows that rating stocks on the basis of expected earnings is widely used. 

The main problem with earnings in the short term, however, is that reported earnings at any given point in time tend to be “noisy”.  They can be distorted by many factors, or manipulated by management. One possible element of 'noise' is a change in the accounting method.  That is why it is better to see consistent growth over a long period of time, the longer the better.

The final thing I want to mention is that rather than absolute earnings, it is better to look at earnings per share (or EPS, which is calculated by taking total earnings and dividing by the number of shares outstanding).  After, all if you own a stock, all you really care about is how much the company made relative to your holdings.  If they give out tons of stock options to employees that dilute you interest, it’s possible that the earnings per share drops despite increasing total earnings. 

Profit Margin

Profit margin is Net Income divided by Gross Revenue (or sales).  The result you get from this calculation shows what percentage of each dollar received makes it to the bottom line as profit.  Like many of the financial ratios, profit margin is most useful when used to compare companies in the same industry.  It would tell you very little when trying to decide between GM and Microsoft.  Without any calculations I can tell you Microsoft has a much higher profit margin.

It is also important to look at how a company’s profit margin has changed over time (say a period of 5-6 years).  Naturally, you would prefer to be bullish on a company that has steadily grown its profit margin.  What you don't want to see is a firm with steadily declining margins (unless you’re contemplating a bearish position of course). 

There are only two ways a company can increase their profit margin.  Speaking in terms of the ratio itself, you can increase the numerator or decrease the denominator.  For the numerator, the company can increase revenues.  For the denominator, the company can cut costs.  Companies that increase revenue, while at the same time cutting costs, get especially high marks for overall profitability.

Interest Coverage Ratio

Few things get investors more nervous than a company that can’t make its interest payments.  Most stockholders buy for the long run, and will hold on during the occasional bad quarter.  Bondholders demand their regular payoff like clockwork, and are very unforgiving if the checks stop coming in. 

There are three major firms in the US (Standard and Poor's, Moody’s, and Fitch) that specialize in judging the credit worthiness of each company.  They each assign a rating that is supposed to indicate the likelihood of a firm defaulting.  Those who receive grades in the top tiers are often referred to as investment grade.       

But you can also look at the income statement to make sure a company can meet the demands of its creditors even during a temporary downturn.  The interest coverage ratio takes the earnings before interest and taxes (or EBIT) and then divides by the interest expense.  This tells you how many times over their interest payments could be met with current income. 

EBIT isn't always itemized on the income statement.  But they all do list their pretax income (in Cisco’s above, it is titled: INCOME (LOSS) BEFORE PROVISION FOR (BENEFIT FROM) INCOME TAXES).  You might be tempted to just divide this number by the current debt payment to get the interest coverage ratio.  Don’t! 

Since the government allows you to deduct interest expense from your taxable income, the pretax income figure has the current interest payments taken out.  You want to know “how many times over can I pay interest from current income", not “how many more times could I pay interest expenses from current income.  So you need to add back the current interest expense to your pretax income before doing the final calculation.

Since Cisco has tons of cash just sitting around doing nothing (about $10 billion in cash, cash equivalents, and short-term investments) and has no debt, this question is not of major importance for them (unless of course you are comparing them to a heavily indebted rival).  But most companies do have debt, and I usually like to see that a firm can cover their interest charges at least three to four times over.

P/E Ratio

Very similar to the earnings per share we began with is the price-to-earnings ratio, or P/E ratio.  It's calculated by taking the current market price of the stock and dividing by its current EPS.  It is used to compare stock prices on a relative basis, meaning that a $100 stock trading at a P/E of 8 is considered "cheaper" than a $20 stock with a P/E of 30.

You might then conclude that stocks with low P/E ratios are always better then high P/E issues.  Unfortunately, that is not always true.  Growth stocks usually deserve a higher multiple than those in mature industries because of higher expectations for future performance. 

It may also seem that low P/E stocks offer a type of safety net, since the market isn't expecting much from them in the first place.  The risk is that those at the bottom might hang around their current price for years and never make a move to the upside.

The easiest way to calculate a P/E ratio uses "trailing" earnings – the real earnings shown on the income statement.  Some analysts like to make a growth forecast for the next year and then quote the stock on a "forward P/E" basis, often called the PEG ratio.  For example, a stock with a current P/E of 50 that is expected to double EPS next year would trade at a forward P/E of only 25.  A forward P/E is always a better way to view the whole value idea, but naturally there are problems deciding exactly what the future earnings growth is likely to be. 

So I tend to rely on the trailing P/E to measure relative value, keeping in mind that a stock trading way above its historical multiple, or well above the industry P/E, had better be up there for a good reason (something like dramatically improved productivity or promising new product or markets).

I also keep in mind that a stock with a low P/E might not be a great bargain if the company is having problems.  But assuming the stock clears the other fundamental hurdles described above, a relatively low-P/E stock compared to its own history or industry average might just be the perfect value you've been looking for.  For a more information on how P/E‘s can be affected by non-cash items, check out my article: P/E Ratios and Accounting for Goodwill. 

Summary

Hopefully this overview showed that you can get useful information from an income statement with very little effort.  Many of these numbers and ratios can be found on most financial websites, but I have always found it useful to quickly scan through the numbers personally.  Every company is different, and once you get used to looking at the numbers directly, you will be able to quickly spot anything that looks unusual. 

You don’t have to have an accounting degree (and I don’t) to find useful information.  That can give you greater confidence when placing your trades, or perhaps make the difference by stopping you from placing an ill-considered one.