Total Revenue less total operating costs gives operating or trading profit. Revenue and costs occurring in a period must be adjusted with adjoining periods to ensure that each period is credited and charged only with what is appropriate. All the assets used in the business have played a part in generating the operating profit which is termed as EBIT earnings before interest and tax.
Fundamental Analysis: The Income Statement
Sales or revenues are the money the company gets for the services or the products sold to the buyer. While sales are sometimes defined differently from company to company, the sales figure is generally recorded when the product or service has been delivered. To obtain a better grasp of what drives sales, investor uses industry analysis techniques to assess the company’s competitive position. Some prefer to look at industries based on their particular strengths, weaknesses, opportunities, and threats, better known as SWOT analysis. The Competitive Strategy assesses five different “forces” that drive industry profitability. The forces include the threat of new entrants, the threat of substitute products, the bargaining power of buyers, the bargaining power of suppliers, and the degree of rivalry among competitors.
Volume is the amount of units sold, which depends on the demand for the product by its consumers. Company’s product demand is increased by management employing various strategies for growth. It could increase volume by expanding into new geography’s, product differentiation, strengthening supply chain and network, joint ventures and strategic alliances.
Pricing its product is attained by the company through the brand image of its product, a competitive edge against its competitors, barriers to entry, economic to scale, low cost leadership and quality of its product.
Cost of goods sold (COGS) is the cost incurred to make the product. There can be a number of variables that affect cost. The three main components of COGS are manufacturing overhead, direct materials, and direct labor costs. Manufacturing overhead costs include such things as indirect materials, labor, utility costs, the factory building, etc. Direct materials costs relate to the components of the product. Direct labor is labor that actually “touches” the product during its creation, such as in the case of assembly line workers.
Operating expenses include selling and general administration expenses. Selling expenses are those expenses associated with the selling of the goods and services. Administration expenses include those costs linked to running the company. The operating expenses are often determined by the competitive strategy being implemented by the company, and how it chooses to manage its overhead.
After arriving at operating profit (EBIT), this profit belongs to and must be distributed among those who have provided the assets. The first are the once who has granted loans to the company which could be banks, NBFCs or investors of the bonds issued by the company. They are payed interest for providing a loan to the company. The loan outstanding can be viewed in the balance sheet of the company at liability sides.
After payment to the lender, the company is liable to pay income tax to the government. The tax rate is assigned by the central government. It could be revised during the announcement of government budget.
In the end, after paying interest and tax from its operating profit to lenders and government the resulting amount is the net profit of the company. This net profit is what the shareholders of the company is likely to get distributed among themselves.
The board of the company decides the amount of profit to be distributed to shareholders. If the management feels that prospects for growth are higher in future, then company distributes certain amount of profit to its shareholders as dividends and keeps the remaining amount in reserves of shareholders’ funds which could be later distributed to them.
In the beginning of our analysis we have already discussed about the company’s products and segments in detail as to what contributes to the sales of the company. Here we shall highlight the details below about the cost of material consumed which constitutes major part of expense for the company.
Income statement analysis example :
Wheat, sugar and oil accounts for nearly 59% of the company’s raw material, out of which wheat flour accounts to nearly 29% of the cost. If in future there is rise in food inflation in the economy then rise in these input products will dent the operating profit of the company.
Transactions that affect both the income statement (IS) and balance sheet (BS) accounts
Following are a list of them:
- Making sales on credit (IS) generates account receivables (BS).
- Selling products (IS) decreases the company’s inventory (BS)
- Selling products or consuming raw materials (IS) involves prior purchases on credit that generate account payables and increase inventory (BS).
- Depreciation expense (IS) is recorded for the use of fixed assets. Its is recorded in the accumulated depreciation account (BS).
- Operating expenses (IS) is a broad category of costs encompassing selling, admin & general expanse:
- Some of these operating costs are prepaid before the expenses are recorded, and until the expense is recorded, the cost stays in the prepaid expenses account (BS).
- Some of these operating costs involve purchases on credit that generate account payables (BS).
- Some of these operating costs are from recording unpaid expenses in accrued expenses liability (BS).
- Borrowing money increases liabilities (BS) and causes interest expense (IS).
- A portion of income tax expense (IS) for the year is unpaid at year-end, which is recorded as an accrued expense liability (BS).
- Net Income (IS) increases retained earning & thus the shareholder’s equity account (BS) whereas paying dividends decreases the aforementioned accounts.