Financial Statement Analysis: How to Analyze an Income Statement

Last week we announced the availability of a free video series Introduction to Financial Statement Analysis. The videos are available on our website at http://www.kaplancollectionagency.com/financial-statement-analysis/introduction/. All the information in the videos is also available in a free download to keep for additional review and future reference.

Last week in this blog we discussed the first video which explains the income statement. The second video provides an introduction to analyzing the income statement. When reviewing an income statement, sometimes just looking at the actual results on the income statement don’t reveal the full story on a company’s profitability.

Dean Kaplan

There are two main ways to analyze the income statement: margins and trends. Margins are calculated by dividing one category on the income statement by another category, typically total revenue, to arrive at a percentage. For example, operating profit divided by total sales calculates the operating margin. The resulting percentage can provide insight into the company’s profitability. Other commonly calculated margins include the gross margin, the pre-tax margin, and the net income margin. Each of these is defined the video and we show how to calculate each one.

In some cases it is easy to know if a margin is very good or very poor. However, in most cases, these percentages often don’t have much meaning on a stand-alone basis.  They need to be compared against something. Comparing the margin of a company to the margin of other companies in the same industry can provide valuable insights. If the profitability margins are lower than the margins for its peers, this can be a warning sign for those considering granting credit to the company.

The other main approach for analyzing an income statement is to look at trends. This means comparing performance of the company during different periods of time. The most common comparisons are performance in one year to the prior year, one quarter to the prior quarter, and one quarter to the same quarter the prior year. However, each of these is a short-term analysis, and while valuable, this does not provide insight on longer-term trends. Looking at performance over the last 3 years or last 5 years provides much more insight.

Credit managers are concerned about risk. If financial performance is relatively stable over a longer period, this implies less risk. If performance is improving over time this is even better. But, if performance is declining, or it changes dramatically from year to year, this is a cause for concern. When performing trend analysis, one can look at the actual amounts, such as the amount of sales or net income, and one can also look at margins. Sometimes a company will have higher profitability from year to year as a result of an increase in sales, but profitability margins may have declined. Analyzing the income statement from different perspectives can help a credit manager understand risk better. The video titled Analyzing the Income Statement shows how to calculate these trends and discusses some items to look for.

The Kaplan Group is a commercial collection agency that specializes in collecting large B2B claims. Financial statement analysis is one of the tools we use to help our clients maximize the return on delinquent receivables. Next week we will discuss the third video in the series which explains the balance sheet.