Accounting 101 — Income Statement Analysis
What is an income statement? Income statement simply put, shows the financial performance of the business over a period of time, usually 12 months, for e.g. between the periods of 1st of January 2023 and 31st of December 2023.
In simplistic terms, the income statement shows you the following, for a period of 12 months
- Sales: How much did you sell and what did you sell?
- Expenses: What costs did you incur during this period?
- Profit/Loss: The bottom line, did you make a profit or loss (Sales -Expenses) during the year.
It is important to caveat, that profit/loss does not necessarily mean cash made or lost during the period, as there are some non cash items in the profit and loss e.g. some sales could have been made on credit or expense incurred on credit together with other non cash transactions e.g. depreciation of assets.
Another Financial statement(FS) , the cashflow statement which will be examined later, shows the cash generated/lost during the year from its operations.
The profit/loss of the year can be simply thought of as an estimate of the financial return generated in a particular period.
This information enables users of the financial statements e.g. shareholders, employees, tax authorities know how a business performed during a particular year, to make relevant decisions e.g. How much tax is due to the government or do I buy more shares or sell my shares etc.
That being said, the income statement like other financial statements has limitations which is, that it is backward looking and doesn’t necessarily have predictive value. Simply put, it shows the performance of a company in the past, which is not necessarily an indicator of future performance.
For example, consider a fashion company in Qatar which sold an extraordinary high amount of goods £100m last year benefiting from World cup Traffic in 2022, this doesn’t mean the company will sell at least £100m worth of goods the next year, as the World cup occurs once every 4 years as such some of these sales are one off entries and will not necessarily be repeated year on year.
It however forms a useful basis, to understand a company’s core operations to generate an expectation of future performance using financial data and other data such as knowledge of the wider economy and industry, company’s competitive strategy etc.
This will be demonstrated in a use case below. However before that, the characteristics of great income statements should be examined
Characteristics of great Income statements ?
There are two principles of great income statements:
- Relevance: Information relevant to the users should be included, for e.g. consider sales, a breakdown of sales by revenue streams is relevant, as it enables users to determine how the entity makes its income from different sources. Companies can choose to limit disclosures, as a rough rule of thumb, the more disclosures a company makes, the more useful income statement and FS as a whole is for analysis.
- Faithful representation: FS statements should be prepared according to IFRS (the international standards) or local standards, for e.g. UK GAAP. This allows for consistent accounting practices to be applied within an industry, and facilitates ease of comparison year on year, or across different companies. This is usually the case in most major economies, and will be corroborated by a statutory audit.
For simplicity, the key take way: is relevance (increased disclosures makes for better income statements as it provides more information), faithful representation: audited FS statements are more reliable than unaudited.
The caveat, is that audits are not perfect, there is always a risk that numbers in income statement might be misstated however audits greatly mitigates that risk particularly audits from Top level professional firms such as the Big 4, Grant Thornton etc;
As such FS data such as income statements should be used together with other data sources to form a more comprehensive picture of an entity and its operations.
Other secondary characteristics of great financial statements include
- Comparability: Having figures is great, but the only way we know how good something is to benchmark it against something else. Financial statements such as income statements are usually benchmarked to figures, such as the PY. This facilitates a variance analysis, to see how performance changed relative to PY.
This will be examined in the use case below.
Use Case: Charterhouse Voice and Data
Ok, Now for a real life example! In this use case, I will be analysing the Income statement for a medium sized technology UK company, Charterhouse Voice and Data for the year ended March 2022. (1st April 23- 30 March 2021)
First off, the first step is to determine if the accounts have been audited, from the independent auditors report in the front page of the FS, it can be readily deduced that the accounts have been audited by Grant Thornton, a top firm.
Hence this gives us additional comfort that the numbers are representative of actual performance of the firm.
Results are shown below, All figures are in £000’s.
From analysis, it can be seen that revenue or turnover increased 7% relative to prior year, this seems positive! However, to determine how great this is, this should be benchmarked against that the wider industry, that is how did the average technology company in the UK perform?
From IBIS world Software Development — Market Size | IBISWorld, the average company grew 6.2%, hence this is amazing! The company is selling more than the average company in the software development industry. So it seems to be doing quite well.
Furthermore the 2021 figures, are for a period of 16 months, while the 2022 figures are for a period of 12 months, due to a change in accounting period. Simply put, the entity is selling a lot more in a lot less time which is great!
Let’s go into a bit more detail, so we sold more than last year, which is great but what exactly drove those sales? In the directors statement it is briefly mentioned that this is due to acquisitions of smaller companies, the question remains though? How much of the sales were due to new acquisitions, others from continued business from PY.
Furthermore software development is quite a broad term and encapsulates on site service, software licenses, maintenance fees etc. The aggregated sales figure gives us limited insight as to what revenue streams are driving sales growth.
Unfortunately, the entity did not provide that additional information as it chose to limit disclosures, as other competitors such as SAP Ltd did, hence leaves out some “relevant” information hence not great. This is potentially an area of further questioning for management, for users of the FS statement.
So in summary, we do know the entity is selling quite a bit more, better than the average company in the UK, however we are not quite sure what revenue streams is driving those sales or how much of those sales were due to acquisitions as opposed to continued operations.
The next step of the analysis is expense analysis, there are several types of expenses and can be classified in one of 2 ways.
Method 1: Direct and Indirect costs.
Method 2: Fixed and variable costs.
Direct costs alternatively known as cost of sales (COS/COGS abbreviation) are costs directly incurred when a sale is made, for e.g. A tech company performing maintenance work for its client, the direct cost incurred will be the contractor fee, for job serviced. Another simpler example will be a third party retail store selling a bag of chips, the direct costs will be the purchase price of the chips.
Indirect costs, are all other costs incurred to provide the service not directly linked to sales for e.g. the rent for the office space, gas bills, electric bills for the company .
In the same breadth, fixed costs are costs that remain the same regardless of the production capacity of the business e.g. rent, fixed costs are usually indirect costs, though this is not always necessarily the case.
Variable costs, are costs that change with level of production for e.g. in the example of Charterhouse, for the sale of licenses, the more licenses the entity sells the greater the variable costs, as it would incur more costs to service more customers. Similarly these are usually associated with direct costs, though this is not necessarily the case.
The bottom line is either method or both methods, can be used to analyse expenses, to understand the nature of the entity’s business expenses to make more informed decisions.
For this case study, both methods will be used with costs being broken down to direct and indirect costs using method 1. Then using method 2, indirect costs being further broken down to fixed or variable costs.
From income statement, it can be seen that COS or direct costs increased 9% while sales increased 7%, this shows that its profit margins are being squeezed as it costs more to sell the same amount, this was due to cost of living crisis and inflation caused by Co-vid and the Ukraine war.
From extract above, GP margin which is essentially the profit margin considering only direct costs, has reduced marginally 1% to 38%.
As such, this analysis will enable us to ask management questions such as How does the company intend to protect its margin, against inflation?
The next step will be analysing Indirect costs. This consist of AE, exceptional, impairment etc.
From the FS line items, it can be seen that the entity had a huge increase in indirect costs, AE or admin expenses increased marginally by 604k/3% and exceptional costs increased significantly by 1406k/85%.
This huge increases in indirect costs are the primarily reason behind the increase in loss for the FY22, which largely offset any increases in gross profit from increased sales.
Ok so lets bring it all together. from the viewpoint, of a potential investor the entity is growing its revenues amazing! However these increased sales, are not necessarily translating to a profit which is primarily due to high levels of indirect costs.
So does that make the entity a lacklustre venture, not necessarily, as it is not uncommon for companies to struggle to turn a profit while growing revenues, the question is, can it turn a profit from these increased sales, if so how?
From analysis above, the most straight forward way to turn a profit will be to control or reduce indirect costs. The question is how much of these costs are variable, i.e. they can be controlled for.
From a quick overview, the exceptional items is the main indirect costs, preventing the entity from turning a profit. Exceptional items are classed as one off expenditures, that the entity does not expect to repeat regularly for e.g. payment of a huge legal fee.
From further analysis, from expenses in the notes of the FS (“relevant disclosures”). It can be seen that the entity has undergone a restructuring process, and is incurring costs such as redundancy pay etc.
However it seems the entity incurred these “exceptional” costs both in FY21 and FY22 hence they do not seem to be a one off, which brings up the question has the entity incurred all relevant costs related to the restructuring.
Management should be queried further, to determine if the entity can control for its “variable ”indirect costs, and if so, if it is able to turn a profit.
In summary, the key take ways are
Income statement shows
- The amount and sources of an entity’s income, this should be benchmarked against prior year performance and the wider industry.
- The entity’s costs, both direct and indirect costs which can be further broken down to variable and fixed costs.
- Whether the entity turned a profit/loss for the entire year.
By performing these analysis, it can give users such as yourself, the framework to ask leading questions to understand more about an entity’s operations, industry performance etc and form relevant deductions based on target objective.
For e.g. an investor seeking to maximize profit, can carry out an income statement analysis, to determine the profit margin of an entity within a particular industry, and benchmark it against the wider industry , to see if its over or underperforming relative to the average.
In the case of Charterhouse, an investor could ask leading questions, such as those listed above to determine if its worthwhile investing capital in Charterhouse or not .
That’s it for this paper. The next step will be to analyse the balance sheet, another FS.
I hope you found this useful, Let me know your thoughts!
