How to Read Financial Statements Part 1

Reading financial statements can be a daunting and time consuming task for many people. In the next few posts I will attempt to condense what to look for in a company's financial statement, presented in an interesting and readable fashion.

There are 3 parts to the Financial Statement

1. Income Statement / Profit & Loss (P&L)
2. Balance Sheet
3. Cash Flow

Lets start with the Income statement (P&L)

Reading the Income statement 

The income statement tells us how efficient a company is at making money during a set period of time.  There's three components to the Income Statement. Revenue, expenses and whether the company made a profit or loss for the period.

Revenue

                                             
Let's use a Supermarket as an example.

Revenue, often referred to as the "Top Line", is the amount of sales that the supermarket made during the year.  Let's say they sold 10,000  products at $1 each, their revenue would be $10,000. If they bought each product for 40cents (40cents x 10,000), their cost of goods sold would be $4000. Gross Profit is derived after deducting the cost of goods sold from the Revenue. In this case the Gross Profit is $6000. For every dollar of sales the supermarket made, they pocketed 60cents (Gross Profit margin of 60%).

Operating Expenses 

They are a group of expenses or cost incurred by the company during the year. Some of these costs include employee's salaries, advertising (Distribution and Selling Expenses), rental costs of their premises (Administration Cost), and any loans they have outstanding (Interest expenses). Depreciation is the wearing out of buildings and machinery over time. Operating profit is derived from subtracting all the expenses from the gross profit.

Net Profit 

 

Net profit, also known as the bottom line, is the total amount of money the supermarket made for the year after it paid income taxes.

If you can understand these 3 components of the income statement, you will be able to deduce how efficient a company is at making a profit and keeping its costs low. As I alluded to earlier, the income statement is for a fixed period of time. It is important to track a company's Income statement over 5-7 years to get a comprehensive picture.

If you haven't been bored to death yet, here are some important things to check on an Income Statement ala Warren Buffet Style.

Key Information from the Income statement

1. Is a company's revenue and net profits growing every year.
2. Is the company able to keep its costs and interest expense low consistently
• What is the % of Expense/Revenue and how consistent it is over the years
3. Gross Profit Margin (How much money a company pockets for every dollar of sales)
• Gross Profit Margin = Gross Profit/Revenue x 100%
• Anything above 40% is considered good according to Mr Buffett.
4. Operating Profit Margin (Proportion of Revenue left after paying for its expenses)
• Operating Profit Margin = Operating Profit/Revenue x 100%
5. What are the profit margins of its competitors.
6. Consistency in results and margins is one of the key indicators that Warren Buffett looks for in an income statement

Note: This is only meant to give investors a brief overview of the main components of a Income Statement. Actual statements have more variables but if you apply the basics principles and practice reading them, it will become easier with time.