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Find Investment Quality In The Income Statement

InvestopediaBy Richard Loth | Investopedia – Mon, Nov 7, 2011

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.

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.

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.

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.

The impact of leverage is picked up in the return on capital (return on invested capital or ROIC) ratio.

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.

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.