The income statement contains a great deal of useful information about a firm. This post shows how to extract and interpret that information. The income statements of Lie Dharma Putra, Inc. (LDP) for the years 2009 and 2008, which are summarized in the next two exhibits, serve as the basis for this post. One item on LDP’s income statement deserves special mention. In 2008, LDP incurred a $32,900,000 special charge. The charge includes costs to close facilities, write down assets, and lay off employees. Because LDP did not discontinue an entire line of business, these changes do not qualify as a discontinued operation, yet this charge might not recur in the near future. Consequently, some analysts would delete this $32,900,000 loss in calculating ratios and evaluating trends.
Vertical analysis examines relationships within a given year. To do this with the income statement, divide each line by the first item, net sales. Net sales are a summary measure of a firm’s total activities, so evaluating each income statement item relative to net sales makes sense. The result yields common-size income statements in percentage terms. LDP’s common-size statements appear in the second exhibit.
The first line of a common-size income statement is always 100% because the net sales figure is divided by itself. The second line of the common-size income statement, cost of products sold divided by net sales, is referred to as the cost of goods sold percentage. For a firm that is a merchandiser, one that simply buys and resells goods without changing their shape or form, this percentage reflects the relationship between the price the firm pays for the goods and the price it charges customers. For a manufacturer, a firm that buys raw materials and component parts and reshapes them into a finished product, the cost of goods sold percentage can also indicate the efficiency of the manufacturing process.
In assessing a firm’s ability to generate cash flows, low costs and consequently low cost of goods sold percentages are desirable. This provides a larger profit per item sold. For every dollar of revenue in 2009, LDP paid about $0.64 to manufacture the associated clothing.
The third line, gross profit (or gross margin) percentage, is calculated either by dividing gross profit by net sales or by subtracting the cost of goods sold percentage from 100%. It reflects the percentage of the sales price that exceeds the cost of goods sold. It measures the percentage of revenue that is available to cover expenses other than cost of goods sold and to contribute toward profits. In 2009, about $0.36 of every LDP sales dollar was available for these purposes. Given that a lower cost of goods sold percentage is desirable, a higher gross profit percentage is preferable.
Two basic strategies exist to increase the gross profit percentage (or, in other words, to decrease the cost of goods sold percentage):
- First, unit selling prices could be increased. This option is limited because of competition from other companies in the firm’s industry.
- Second, efforts can be made to reduce the cost of goods sold. This can be done, for example, through more astute purchasing (such as buying in bulk to obtain a discount) or a more efficient manufacturing process.
The fourth line of LDP’s common-size income statement reflects the relationship between selling, general, and administrative expenses and net sales. Managers have substantial control over these costs, and percentages that increase over time are usually viewed with disfavor.
Of the remaining items in the second exhibit, the two most important are the operating income percentage and the net income percentage. The operating income percentage is an indicator of management’s success in operating the firm. The numerator, operating income (or loss), excludes both interest expense and taxes. Because these expenses are not directly affected by operating (buying and selling) decisions, the operating income percentage is a better reflection of how management handles the day-to-day affairs of the firm. The net income percentage reflects the firm’s overall profitability, after interest and taxes, relative to its level of activity (net sales). Both ratios are indicators of a firm’s financial success.
Trend analysis involves comparing financial statement numbers over time. One way to implement this is to compare the common-size income statement items over time. The trends in LDP’s cost of goods sold percentage and its gross profit percentage are favorable.
For example, the cost of goods sold percentage decreased from 67.6% in 2008 to 63.5% in 2009. This decrease could reflect decreases in the prices of raw materials, increased demand for its products (allowing an increase in selling prices) or efficiencies in the manufacturing process.
The trend in selling, general, and administrative expenses as a percentage of net sales is not favorable. They have increased from 27.4% of sales to 29.2% of sales. However, as the first above exhibit shows, the total dollar amount of these costs has declined. Both operating income and net income show very desirable trends. However, if LDP’s special charge is not expected to recur, the operating income percentage and net income percentage should be adjusted for purposes of assessing performance and forecasting future results. To adjust the 2008 operating income percentage, the special charge should be added to operating income because it has already been subtracted in arriving at that number.
Because net income is an after-tax figure, the adjusted net income percentage must be modified on an after-tax basis. The first exhibit indicates that the after-tax effect of the special charge was $15,200,000. The after-tax cost is smaller than the pre-tax cost of $32,900,000 because it reflects the benefit of a reduction in taxes due to the loss. The adjustment is accomplished by adding the $15,200,000 after-tax loss to net income.
Using these adjusted percentages for 2008 as a benchmark, LDP’s performance in 2009 has still improved, but not to the degree as the unadjusted percentages indicated.
Horizontal analysis is another form of trend analysis. It uses the figures from a prior year’s income statement as the basis for calculating percentage increases and decreases over time. Below exhibit contains a horizontal analysis of LDP’s income statements. The figures in the exhibit are obtained by dividing the items in the 2009 income statement by their corresponding amounts in the 2008 income statement.
The exhibit shows that net sales decreased 11.1% (100% – 88.9%) between 2008 and 2009. A decrease in sales is often a cause of major concern. A sales decline could reflect a decrease in sales activity (number of units sold) or a decrease in unit selling prices. Either of these causes could have adverse effects on profitability. Additional research regarding LDP indicates that the sales decline was due primarily to two other factors. First, LDP intentionally adopted the strategy of reducing its reliance on wholesalers, who are intermediaries that purchase the company’s products and resell them to retail vendors, such as department stores. LDP concluded that its relationship with certain wholesalers was not sufficiently profitable to warrant continuation.
The other major reason for the decline in sales was that LDP discontinued its own European operations, which had a negative effect on sales. To replace these operations, however, LDP granted a license to another organization that is more familiar with the European market. The license permits this organization to sell LDP products in exchange for royalty payments. The exhibit shows that royalty income increased by 30%. Thus, LDP’s strategy was to trade the profit generated by its own European operations for the royalty income generated by its licensee.
The strategies of LDP, described above, that affected sales should also have impacted expenses. Cost of products sold is the largest single expense item. The horizontal analysis shows that this item declined 16.5% (100% – 83.5%) from 2008 to 2009. The decrease in cost of products sold is larger than the decrease in sales (11.1%). This suggests that the actions taken by LDP will have a positive effect on profitability. The decline in cost of products sold is also attributable to two other reasons; LDP was able to find less expensive sources of raw materials, and LDP improved the efficiency of its manufacturing operations. The latter was accomplished, in part, by plant closings, the costs of which were contained in the 2008 income statement. Also note that the decline in cost of products sold relative to sales is consistent with the results of the common-size income statements (refer to the first exhibit of the previous section) that showed that the cost of products sold had decreased as a percentage of sales.
The horizontal analysis indicates that the percentage change in operating income for 2009 is not available. This is due to the fact that an operating loss was generated in 2008 and operating income was generated in 2009. Although the 2009 figure can be calculated (36,887 / -4,584 = -805%), care must be exercised when dealing with negative numbers. The negative denominator yields a negative percentage, yet the income in 2009 is much more positive than the 2008 loss. Even if absolute values are used, knowing that the 2009 operating income is eight times as large as the 2008 operating loss is not particularly insightful. Regardless of the difficulties with this calculation, the trend in operating income is extremely favorable.
The trend in net income is also quite favorable. Net income in 2009 is 20 times greater than 2008 net income. This result underscores another pitfall in calculating ratios: the small denominator problem. The large percentage increase is not primarily due to 2009 being so superlative. Rather, the small net income generated in 2008 has the effect of inflating the calculated value. Although net income improved substantially in 2009, a percentage increase of 2,015.9% prLDPably overstates the improvement.
Other Ratios [ROE and ROA]
Several ratios link the income statement and the balance sheet. Return on shareholders’ equity (ROE) is of utmost importance to shareholders. To calculate ROE, divide net income by average shareholder’s equity:
ROE = Net income / Average shareholder’s equity
ROE relates the earnings generated by a firm to the assets invested by its shareholders. It is obviously in the shareholders’ best interest to have larger earnings generated on their investments. A potential investor, faced with competing investment choices, will use ROE to help identify the preferred investment.
The denominator of ROE is average shareholders’ equity. Because net income is earned over the course of a year, it makes sense to use the firm’s average shareholders’equity during the year. As a practical matter, average shareholders’equity is usually calculated by averaging beginning and end-of-year shareholders’ equity amounts, which are found on the balance sheet.
LDP’s 2009 ROE is:
ROE = $22,558 / ($138,077 + $113,157) / 2 = 18.0%
A ROE of 18% is very close to LDP’s industry average. The 2009 ROE compares extremely favorably to the 2008 ROE of 0.8%.
Another important ratio is return on assets (ROA). This ratio relates a firm’s earnings to all the assets the firm has available to generate those earnings. ROA differs from ROE in that ROE utilizes only the assets that the shareholders supplied. ROE measures management’s success in using the assets invested by shareholders, whereas ROA measures how successfully management utilized all the assets entrusted to it. To calculate ROA, divide net income, adjusted for interest expense, by average total assets:
ROA = [Net income + Interest expense] / (1 – tax rate) / Average total assets
Why is interest expense added to net income in the numerator? Recall that a firm can acquire assets from two sources: “owners” and “creditors“. Interest expense is a cost incurred to acquire assets from creditors (e.g., interest expense on bank borrowings). It arises from a financing decision (LDPtaining funds from creditors rather than owners), not an operating decision (utilizing assets). Because ROA is designed to measure managers’success in utilizing assets, interest expense is irrelevant. Its effect on net income should be eliminated when calculating ROA.
Interest expense has direct and indirect effects on net income, and both effects should be eliminated. Regarding the direct effect, because interest expense has already been subtracted in calculating net income, it is now added back. The indirect effect relates to taxes. Because interest expense is a deduction for tax purposes, tax expense is lower and net income is higher by an amount equal to interest expense multiplied by the tax rate. Therefore, to adjust fully for the elimination of interest expense, net income must be increased by interest expense and decreased by interest expense multiplied by the tax rate. The difference between these two amounts is interest expense multiplied by 1 minus the tax rate):
+ Interest expense
– Interest expense x tax rate
Interest expense x (1 – tax rate)
Eliminating the effects of interest expense facilitates the comparison of asset utilization across firms that have different amounts of debt. Financial statements disclose, in the notes, firms’ tax rates. LDP’s effective rate in 2009 was 40.9% and its ROA for 2009 was:
ROA = $22,558 + $305 (1 – 0.409) / [($196,033 – $174,788)] / 2 = 12.3%
LDP’s 2009 ROA greatly exceeds its performance in 2008. The dramatic improvements in LDP’s ROE and ROA reflect the success of its operational changes mentioned above.
The final ratio discussed in this section is times interest earned. Because profits ultimately are a source of cash, and because cash is necessary for the payment of interest charges, creditors are concerned about the relationship between profits and interest expense. The times interest earned ratio shows how many times interest expense is covered by resources generated from operations, and creditors prefer higher times interest earned ratios. It is calculated by dividing earnings before interest and taxes by interest expense:
Times interest earned = Earnings before interest and taxes / Interest expense
Earnings before interest and taxes, not net income, is used in the numerator. Because interest expense is already deducted in calculating net income, net income understates the resources available to cover interest expense. Tax expense should not reduce the numerator because, in a worst case scenario, as income declines, taxes would be eliminated.
LDP’s income statement, presented in the very first exhibit of this post, does not contain a line item for income before interest and taxes. The easiest way to calculate this figure, given LDP’s income statement format, is to add interest expense to income before taxes. In 2009, LDP’s income before interest and taxes would be determined as follows:
Income before taxes = $38,187,000
Interest expense = 305,000
Income before interest and taxes = $38,492,000
LDP’s 2009 times interest earned ratio is 126.2:
Times interest earned = $38,492 / $305 = 126.2
This ratio indicates that interest expense is covered 126.2 times at present income levels. This is an outstanding ratio and reflects that LDP has little outstanding debt. Given that potential creditors would look very favorably on a ratio this large, LDP would likely have little problem securing additional financing, if it so desires.