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I was asked a question on Twitter a couple days ago with regards to how to read an Income Statement. The question was “do I look at the bottom line where it says Net Income/(Loss)” and my answer was no, you look at “Operating Income”. Operating Income is the line which indicates how profitable a company is when doing business. There are other items which appear on the Income Statement which are outside the control of a corporate entity, but still need to be reflected on the Income Statement – such as Income Tax.

 

Companies do not have control over the rate of Corporate Income Tax. This is set by the Federal Government, in conjunction with whatever Province the Company resides in. In the case of Ontario the Corporate Tax Rate is 28.5% but will be reducing shortly. Companies do not have control over this, and therefore the reduction in income due to having to pay Corporate Income Tax should not be a reflection on a Corporation’s ability to run a profitable business.

 

There are other items which I reflect in my example below. Let us pretend that it is a multinational mining company. On the line “Equity Income” this would be the income earned by way of owning a proportion of another corporation. In this case the company (let us pretend we are Co.A) has no control (i.e., less than 50% ownership) over Co.B. It just recognizes a portion of the income of Co.B as part of Co.A’s financial statements. The details would be spelled out in the Disclosure Notes, which always accompany external Financial Statements. As Co.A has no controlling interest in Co.B again, this number is not a reflection on how well Co.A is turning a profit based on its operating activities.

 

Now as Co.A is a multinational mining company there are situations in which I needs to write-off items such as an entire mine (which would have been an asset on the Balance Sheet) due to “Acts of God” – i.e., mountain collapsing or whatnot. In situations such as that Co.A again has no control over the mine needing to be shutdown and thereby no longer being a viable long-term asset. As this would be something completely out of Co.A’s control (Act of God) it would be an extraordinary event.

 

So to the average person it looks like the year 2008 was the most profitable and it would be assumed that the management was doing a very good job compared to prior years. And the question would why did income drop from $94.75 to $38.25 in the following year. But if you look at Operating Income you’ll note that actually 2008 had a drop in Revenue, and increased Staff Costs – which could be due to paying severances or whatnot – which would be disclosed in the Disclosure Notes. And though 2007 appears to have the least amount of income, it actually out-performed 2008.

 

So when looking at a set of Financial Statements one should not look at the last number. Look at all the numbers, and take note of items such as any drops in billings, increases in Expenses, and why these numbers changed. And if there are constant write-offs occurring then that is a sign that either the company is making poor investment choices or it is a reflection on the type of industry the company is involved in. As Co.A is in mining it is to be expected that there will be a certain level of uncertainty with regards to its mines, labour relations and so forth.

 

Financial Statements are not just the P&L (Income Statement) and the Balance Sheet. You need to look at all the component parts, which are:

 

  • Balance Sheet
  • Income Statement
  • Cash Flow Statement
  • Disclosure Notes

 

The Cash Flow Statement will let you know how well the company is performing with regards to generating cash flow. If it is asset rich and cash poor, that is something to consider. The Balance Sheet, you can look at the level of liquidity – how able is it to pay off its immediate debts (accounts payable). What is the level of investment in assets, the level of equity and so forth.

 

The disclosure notes will tell you what accounting policies a company is using. It will indicate what its long-term debt obligations are, if there are any hybrid securities, and if it has unionized labour, what is its pension funding obligations and how much it may still owe to the pension fund.

 

Using Financial Ratios are more then a good idea, they are essential when looking at a set of Financials to determine if the company would make a good investment for a potential stockholder or bondholder.

Income Statement

2009

2008

2007

2006

Revenue
Billings

120

90

110

100

Cost of Goods Sold
Gross Margin

120

90

110

100

Expenses
Staff Costs

30

33

29

31

Rent

5

5

5

5

Utilities

1

1

1

1

Office Costs

1.5

1.5

1.5

1.5

Depreciation

1.75

1.25

1.5

2

Meals & Entertainment

1

0.5

0.5

2

Travel

0.5

1

1

2

Maintenance & Repair

1

1

1

1

Equipment Lease

1

1

1

1

Total Expenses

42.75

45.25

41.5

46.5

Operating Income/(Loss)

77.25

44.75

68.5

53.5

Equity Income

5

3

8

3

Gains/(Losses) on Disposals of Assets

4

-10

2

-1

Other Income/(Losses)

9

-7

10

2

Net Income Before Taxes

86.25

37.75

78.5

55.5

Taxes

10

10

10

10

Net Income After Taxes

76.25

27.75

68.5

45.5

Extraordinary Gain/(Loss)

-50

100

-100

0

Taxes

-12

33

-33

0

Net Income/(Loss)

38.25

94.75

1.5

45.5

 

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