Quantitative Methods of Evaluating Businesses and Investments - The Income Statement: Key Calculations
When evaluating companies, checking their financial statements is a good place to start. For the Series 65 exam, you should be able to identify components of the income statement that determine the health of a company.
The income statement allows you to compare revenues to expenses, among other items. The following key calculations allow an IA to determine if a company is profiting from its own operations, what its net income is, and the amount of cash a company generates and uses in a period. We will discuss each in more detail below.
|7.1: Operating income = Gross income - (operating expenses + depreciation)
7.2: EBIT = Revenue - operating expenses
(EBIT: Earnings Before Interest and Taxes)
7.3: Net income = Total income - depreciation, interest, tax liabilities and other expenses.
7.4: Cash flow = Net income + depreciation +/- other charges to income
Formula 7.1: Operating income does not include things such as investments in other firms, taxes, interest expenses or nonrecurring items, such as cash paid in a lawsuit settlement. Operating income is also known as operating profit or recurring profit. Gross profit is often referred to as the gross margin of a company, and operating expenses are often referred to as thecost of goods sold (COGS).
Essentially, operating income represents income received from core operations, minus the cost of day-to-day functions and the loss accumulated on tangible assets. Operating income is important for investors because it shows if a company's working base is profitable. A low operating income can raise questions over whether too much is being spent on marketing or salaries, or whether the equipment is being misused, resulting in a higher than necessary rate of depreciation.
Formula 7.2: EBIT. One of the most important figures to consider on a company's income statement, EBIT determines a company's financial performance and includes all profits (both operating and non-operating) before interest and income tax deductions.
Another EBIT measure is EBITDA, which is Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA can be used to analyze the profitability between companies and industries because it eliminates the effects of financing and accounting decisions. However, this is a not a GAAP (Generally Accepted Accounting Principles) measure in that it allows a greater amount of discretion in what is and is not included in the calculation. This also allows the company to change the terms of its calculation from one reporting period to the next.
A common misconception is that EBITDA represents cash earnings. EBITDA is a good metric to evaluate profitability, but not cash flow. Consequently, EBITDA is often used as an accounting gimmick to dress up a company's earnings. It is key that investors also focus on other performance measures to make sure the company is not trying to hide something with EBITDA.
The following article EBITDA: The Good, The Bad, And The Ugly sheds more light on this ratio.
Formula 7.3: Net Income is a company's total earnings, or profit. Net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. This number is an important measure of how profitable the company is over a period of time. The measure is also used to calculate earnings per share.
Formula 7.4: Cash flow is essentially the amount of cash a company generates and uses during a period, calculated by adding non-cash charges (such as depreciation) to the net income after taxes. Cash flow can be used as an indication of a company's financial strength. Cash flow is crucial to companies: having ample cash on hand will ensure that creditors, employees and others can be paid on time.