Deciphering financial statements for non-financial professionals - Part 5

October 17, 2014

A Going Concern

This fifth post in my Deciphering Financial Statements for Non-financial Professionals series addresses how you, as a financial statement reader, can use the statement of operations to understand and evaluate a company’s ongoing activities. In this series of posts, I will provide insight into financial reporting and related topics geared toward non-financial professionals who need to understand financial statements as part of their professional roles. I encourage you to also read the other installments in the series, past and future, particularly the introduction published on July 25, 2014 as that post sets the scene for the series and includes a number of resources you may find useful as you go along.

Some may find it useful to have a statement of operations available while reading this post, which can be found at page 4 of the sample financial statement.

A statement by many names

The statement of operations goes by many names: income statement, statement of comprehensive income, statement of loss. Whatever you choose to call it, many people revere it for revealing the truth of a company’s operational health - the all-telling ‘bottom line’. I’ve expressed my personal admiration for the statement of operations’ little brother, the statement of cash flows, in a previous post but I do acknowledge the usefulness of the detail contained within the statement of operations and thus its importance in the evaluation of financial statements. This statement is comprised of several sections, which may or may not be present in all financial statements depending on the company’s specific operations.

Income from making and selling stuff

The section at the top of the statement summarizes the company’s revenues and its expenses directly related to producing those revenues, often referred to as costs of sales, and the calculated net of the two, usually called gross margin or gross profit. Gross margin, either as a dollar amount or percentage is a valuable indicator of a company’s ability to generate income from the sale of its products, representing the amount earned by the company to firstly cover their fixed expenses and then to generate profits.

Indirect operating expenses

Next down the page you’ll find a table of operating expenses, which includes such items as administrative salaries, rent, utilities and depreciation of assets. These expenses are vital to the operation of the company, although in a manner indirect to the production of revenues. Interest expense and related financing charges are often grouped in this section or may be separated into a section below with an extra subtotal. Regardless of the presentation within operating expenses, a subtotal for net income from operations, excluding other income/expenses and income taxes, will be presented with these items being segregated to provide the reader with a clearer view of the results from regular, ongoing operations. This separation of income taxes attempts to present to the reader the total operating income before the impact of taxes, which may be impacted by timing, tax strategy, varying tax rates and tax loss carryforwards.

Comprehensive what?

Comprehensive income is a bit of a confusing concept. In a nutshell it’s a company’s after tax net income, net of gains or losses on items that will not be realized until some future date. Items such as the value of common shares held for investment purposes can fluctuate wildly in value over time and, since they are recorded at fair value on the holder’s statement of financial position, these fluctuations could render net income meaningless if those fluctuations in value were recorded in net income. To alleviate this problem, such items were given their own little section at the bottom of the statement of operations called ‘other comprehensive income’, where the impact of those fluctuations remain until the company disposes of those items at which time the ultimate net gain or loss will usually go through net income, but not always. If the company has activity specifically within comprehensive income, it will present an additional category in shareholders’ equity entitled ‘accumulated other comprehensive income’. This balance aggregates all transactions recorded in other comprehensive income that are yet to be recognized in net income.

What does it all mean?

So how does one evaluate the health of a company through examination of its statement of operations? Firstly, it’s important to remember that you’ll need to consider a company’s financial statement as a whole and compare it to industry peers when doing such an evaluation. Particularly with the statement of operations, its best to examine multiple years of data side by side, with five years usually being enough to reveal significant trends while still being relevant to the current day operations. Here are a few handy ratios that you may find useful.

Gross Margin = gross profit / net sales

This ratio, calculated as a percentage, reveals how profitable a company’s products are in isolation. Margins vary, but the rule of thumb here is the higher, the better. Generally, the higher the margin, the less activity the Company is required to have in order to make a profit.

Earnings per Share = net income after tax / weighted average number of common shares

This is an important enough ratio that it’s presented on the face of the statement of operations, located right down at the bottom of the page. It’s a simple way to determine how much the company earned in comparison to the number of shares outstanding, which nicely factors in shareholder dilution.

Times Interest Earned = net income before interest and tax / interest expense

This is of particular interest for companies that fund their operations largely through debt as it provides an indication of a company’s ability to service its loans. The higher the ratio, the better, and if it’s getting close to 1:1, the company may be struggling. It’s important to note that this isn’t a cash flow measure and so this ratio is a slightly blunt instrument in that respect.

EBITDA: earnings before interest, taxes, depreciation and amortization

Okay, so this isn’t a ratio but I thought it warranted discussion as many people look to EBITDA as a raw indicator of a company’s profitability. There is some variance in practice in the calculation of EBITDA, but it’s generally what it sounds like.

These are simple ratios specific to the statement of operations and there are many others that span the financial statements to provide deeper insight into a company’s health. I’ll cover such ratios in a later post once we’ve walked through a few further aspects of the financial statements.

I hope that you’ve found this post to be useful and informative - don't forget to follow me so you don't miss my future posts.

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