Would you invest in a company just because they are making profits? Does making profit guarantee that the company is good for investment?
A balance sheet helps us understand how much debt a company holds. Whereas an Income Statement shows us how much profit it generates to become debt-free. For a potential investor, income statement helps to assess the company’s recent performance. Hence, stakeholders rely on this statement to understand the business operations.
Analysing an Income Statement is the best way to check how successful a company is. It reveals at what rate is the revenue growing. These factors play an important role in deciding whether to invest in a company or not.
Income Statement is also referred to as Profit & Loss statement. It records all the revenues and expenses. This statement shows a business’ performance over a year.
We learnt how to analyse a Balance Sheet in our previous article. Today, lets focus on how to read an Income Statement.
Let’s break this down and understand every line in this statement –
The income section is usually divided in 2 parts. Revenue from operations and other revenue. Let’s observe these figures one-by-one.
- Revenue from Operations
Revenue from operations are the funds earned from the normal business operations. The primary product/service offered by a company forms their main source of income. For example, Dabur India is a Fast-Moving Consumer Goods (FMCG) company. It’s main source of income are by selling daily consumer products. This includes healthcare, oral care, hair care products, health supplements, etc.
Here we can observe that revenue has increased by 1.99%.
While reading an income statement, always check the footnotes to each reported data. Footnotes provide us with more insightful details. For example, revenue from different operations.
This makes analysing data easier and more useful.
- Other Income
Other Income are income generated from the sources other than normal business operations. The data alone gives us no useful information. Hence, let’s check for the footnote calculations for more details.
Interest income and gains or losses arising from various investments are recorded here. These incomes do not form a part of a company’s normal operation.
These are funds spent on operations to keep generating revenue from business activities. It includes cash as well as non-cash expenses.
Here is Dabur India Limited’s expense head from its Income Statement –
- Cost of Material Consumed
Cost of material consumed includes cost incurred during manufacturing and selling of the goods.
It is calculated as opening stock plus current-year purchases less the closing balance. Dabur India being an FMCG company, they incur packing expenses too. We can note the amount spent on each activity by observing this footnote.
- Finance Cost
Finance cost are also known as borrowing cost. It includes cost involved in the borrowing of money to build or buy assets. Interest paid on borrowings are recorded as finance cost. This includes short term as well as long term borrowings. It may also include legal charges incurred by the company.
It is calculated as a percentage of borrowings. In Dabur’s case, the finance cost has decreased by 16.85%.
- Depreciation and Amortisation
Depreciation and amortisation cost is one of the most common expenses. The value of an asset decreases over time due to its use and wear & tear. Such decrease in the asset value is called deprecation. Depreciation is calculated on tangible assets. Whereas, amortisation is calculated on intangible assets like patent, trademark etc.
Dabur India’s depreciation expenses have increased by 24.62%. This reduces the net profit of the company which further reduces tax expenses.
C) Profit Before Tax (PBT) and Tax Expenses
Profit Before Tax is the income on which tax is calculated. It is calculated after subtracting all the expenses from the revenue generated.
In our case, the profit before taxes and tax expenses shows no significant change. Let us have a look at its notes to accounts –
- Deferred Tax
Deferred tax is the difference from the previous year’s tax payment. This happens due to the difference in timing or the difference in tax paid. We can look for deferred tax on the liability side and deferred tax asset on the asset side of the balance sheet.
Deferred tax asset means that the company paid extra tax in the current year. This means that their future tax obligation will reduce.
Deferred tax liability means that the company paid less tax in the current year. This decreases current year’s expenses. This leads to increase in the net profit.
- Minimum Alternative Tax (MAT) Credit Entitlement
There are two types of taxes. The general company tax and Minimum Alternative Tax (MAT). A company must pay the highest of these two taxes. The tax credit earned is the difference between the amount payable under MAT and the regular tax.
For example, if my normal tax amount is of Rs. 1,50,000 and MAT is of Rs. 2,00,000; I must pay higher amount which is Rs. 2,00,000.
The difference between these two amounts will be my MAT credit entitlement. That is, Rs. 2,00,000 – Rs. 1,50,000 = Rs. 50,000.
This is further deductible in the next accounting year.
D) Profit After Tax (PAT)
Profit After Tax or the Net Profit is the total income earned in the current year. Find out the percentage change in the net profit to observe the growth of the company. A negative number here would indicate loss. In our example, Dabur India has generated a profit od Rs. 1,447.92 crores.
When net profit increases, retained earnings tend to increase. This is a positive sign. Retained earnings is a portion of the net profit which is reinvested in the business. It is good, because it means the company is staying profitable.
Recommended watch: You can use quarterly net profits to pick fundamentally strong stocks for swing trading.
We can calculate several ratios from an income statement. They reveal different information about the profitability of the business. For example, various profit margin ratios. This topic will be covered in our next article.
- Earnings Per Share (EPS)
Earnings Per Share is one of the many indicators one needs to observe before investing. It indicates how much the company is earning per ordinary share. In our example, Dabur India Limited is earning Rs. 8.18 per share.
Related: Watch what are shares in Hindi?
EPS calculation from the footnotes –
The company reports that 1,76,69,35,235 shares are outstanding in the market. We calculate EPS by dividing total profit after tax by the outstanding number of shares. In this case:
Rs. 1,447.92 crores divided by 1,76,69,35,235 yields Rs. 8.18 per share. A higher EPS indicates greater value.
Observe this chart displaying last five years EPS trend –
|Year||March 2020||March 2019||March 2018||March 2017||March 2016||March 2015|
People generally form an opinion after checking the company’s net profit. But a smart investor drills down the financial statements. You cannot judge a person based on his single quality. Likewise, the profitability alone can be deceiving.
Analyse the trends of the past years using profitability ratios. Understand and observe the change in revenue and expense items over time. Start tracking the company’s EPS. At what rate is it increasing or decreasing?
Income statement can help with the decision of whether to invest in the company or not. To learn more about how to become a better investor, visit our YouTube channel. Open a Demat account with SAMCO and start investing your money smarty!