To a large degree, it is the quality and growth of a company's earnings that drive its stock price. Therefore, it is imperative that investors understand the various indicators used to measure profitability. The income statement is the principal source of data to accomplish a profitability analysis, which should cover at least a five-year period in order to reveal trends and changes in a company's earnings profile. (To learn more basics on the income statement, see Understanding The Income Statement.)

Tutorial: How To Analyze Earnings

Accounting Policies
With regard to the income statement, investors need to be aware of two things related to a company's accounting practices. First, the degree of conservatism, which indicates the degree of investment quality. The presentation of earnings depends, basically, on three accounting policies: revenue recognition, inventory valuation and the depreciation method. Briefly stated, a completed sale, last in, first out liquidation (LIFO) rather than first in, first out liquidation (FIFO) valuation and shorter term depreciation periods, respectively, would produce higher quality reported earnings. (For related reading, see Inventory Valuation For Investors: FIFO And LIFO.)

Investors will be alerted to any changes and their impact on performance figures in a company's accounting policies in the notes to financial statements. Investors need to read these qualifying remarks carefully.

Sales
While the so-called "bottom line" (net income) gets most of the attention from financial analysts and investors in any discussion of profit, the whole earnings process starts with a company's revenue, or net sales. The growth of this "top line" figure is a key component in producing the dollars needed to run a company profitably. A healthy sales growth rate generally defines a growing company and is a positive investment indicator.

For investors, all sales increases are good, and can occur as a result of sales growth through more unit volume from existing products or services, the introduction of new products or services, price increases, acquisitions and, for international sales, the impact of favorable exchange rates. However, some increases should be viewed more favorably than others. There's no question that greater unit volume is the best growth factor, followed by product-line expansion and new services. Price increases, especially those above the inflation rate, have their limits, as does sales growth through acquisitions. As applied to companies with foreign operations, the currency translation effect into U.S. dollars, either positive or negative, will even out over time.

Positive investment quality in the sales account comes from growth in better unit volume and the maintenance of reasonable pricing.

Margin and Cost Analysis
In the income statement, the absolute numbers don't tell us very much. A simple vertical analysis (common size income statement) - dividing all the individual income and expense amounts by the sales amount - provides profit margin and expense percentages (ratios) for the whole income statement. Looked at over a period of five years, an investor will have a clear idea of the consistency and/or positive/negative trends in a company's management of its income and expenses. The success, or lack thereof, of this important managerial endeavor is what determines, to a large extent, a company's quality of earnings. A large growth in sales will do little for a company's profitability if costs grow out of proportion to revenues.

The term margin is used to express the comparison of four important levels of profit in the income statement - gross, operating, pretax and net - to sales. Aside from monitoring a company's historical profit performance, these profit margins (ratios) also can be used to compare a company's profitability metrics to those of its direct competitors, industry figures and the general market.

Unusual Items
Also known as special, extraordinary or non-recurring, these items, generally charge-offs, are supposed to be one-time events. When they are, investors must take these unusual items, which can distort evaluations, into account, particularly when making inter-annual profit comparisons.

Unfortunately, in recent years, companies have been taking so-called "big-bath" write-offs with such regularity that they are becoming commonplace rather than unusual. Large multi-year charges on the income statement are increasingly distorting corporate earnings. Needless to say, evidence of undue use of major charge-offs is not indicative of investment quality. This practice is another reason why some financial analysts prefer to work with operating and pretax income numbers to evaluate a company's earnings, thereby eliminating the distortions of unusual items to net income. (To continue reading manipulating the books, see Cooking The Books 101.)

Traditional Profit Ratios
In addition to profit margin ratios, the return on equity (ROE) and return on capital employed (ROCE) ratios are widely used to measure a company's profitability. ROE measures the profits being generated on the shareholders' investment. Expressed as a percentage, the ROE ratio is calculated by dividing net income (income statement) by the average of shareholders' equity (balance sheet). As a rule of thumb, ROE ratios of 15% or more are considered favorable.

The ROCE ratio expands on the ROE ratio by adding borrowed funds to equity for a figure showing the total amount of capital being used by a company. In this way, a company's use of debt capital is factored into the equation. For this reason, conservative analysts prefer to use the ROCE ratio as a more comprehensive evaluation of how well management is using its debt and equity capital. This percentage ratio will vary among companies, but suffice it to say, that investment quality is represented by a higher rather than a lower figure. (To read more, see Spotting Profitability With ROCE, Measuring Company Efficiency and Keep Your Eyes On The ROE.)

The impact of leverage is picked up in the return on capital (return on invested capital or ROIC) ratio. (To read more, check out Spot Quality With ROIC.)

Earnings Per Share
While an absolute increase in net income is a welcome sight, investors need to focus on what each share of their investments are producing. If increased net income comes as a result of profits from increased share capital, then earnings per share (EPS) is not going to look so great, and could fall below the previous year's level. An increase in a company's capital base dilutes the company's earnings among a greater number of shareholders. (To learn more, read Types Of EPS and How To Evaluate The Quality Of EPS.)

Because of this circumstance, a company's net income, or earnings per share, is expressed as basic and diluted. The former represents EPS as of the balance sheet date as per the number of actual shares outstanding and net income as of a certain date, which is generally the company's fiscal year-end. Diluted EPS captures the potential amount of shares that could be outstanding if all convertible bonds, stock options and warrants were exercised. While such a consequence is highly unlikely, it is possible. In terms of the investment quality of the income statement, a significant spread between basic and diluted EPS should be seen as a negative sign.

Conclusion
Logic tells us that growing, profitable companies are generally attractive investment opportunities. However, how that growth is achieved is more important than the absolute sales and income numbers. In addition, conservative accounting policies, substantive sales growth, consistent and/or improving profit margins, the absence of outsized write-offs, above average returns on equity and capital employed and solid earnings per share performance are the hallmarks of top-level investment quality. It is this set of attributes that investors should attempt to find in the income statement before they invest.

Related Articles
  1. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
  2. Credit & Loans

    What's a Nonperforming Loan?

    A nonperforming loan is any borrowed sum where the borrower has failed to pay scheduled payments for at least 90 days.
  3. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
  4. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  5. Economics

    Understanding Cash and Cash Equivalents

    Cash and cash equivalents are items that are either physical currency or liquid investments that can be immediately converted into cash.
  6. Economics

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  7. Investing

    How To Calculate Minority Interest

    Minority interest calculations require the use of minority shareholders’ percentage ownership of a subsidiary, after controlling interest is acquired.
  8. Home & Auto

    When Getting a Rent-to-Own Car Makes Sense

    If your credit is bad, rent-to-own may be a better way to purchase a car than taking out a subprime loan – or it may not be. Get out your calculator.
  9. Options & Futures

    An Introduction To Value at Risk (VAR)

    Volatility is not the only way to measure risk. Learn about the "new science of risk management".
  10. Investing Basics

    3 Companies That Hate Debt Financing

    Learn how companies such as Chipotle, Bed Bath & Beyond, and Paychex are able to maintain impressive levels of growth without debt financing.
RELATED TERMS
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the ...
  2. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  3. International Financial Reporting ...

    A set of international accounting standards stating how particular ...
  4. Revenue

    The amount of money that a company actually receives during a ...
  5. Balance Sheet

    A financial statement that summarizes a company's assets, liabilities ...
  6. Equity

    The value of an asset less the value of all liabilities on that ...
RELATED FAQS
  1. What are some examples of general and administrative expenses?

    In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>
  2. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  3. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  4. How often should a small business owner go through a bank reconciliation process?

    Small business owners should go through the bank reconciliation process at least monthly, and many business consultants recommend ... Read Full Answer >>
  5. What is the difference between recurring and non-recurring general and administrative ...

    The difference between recurring and nonrecurring general and administrative expenses can best be understood as the difference ... Read Full Answer >>
  6. How can I find net margin by looking a company's financial statements?

    In finance and accounting, financial statements represent the fundamental means of analyzing a company's financial position, ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!