Analyze and Read an Income Statement

After preparing the income statement for the fiscal period, the financial analyst should analyze the income statement to find out the strengths and weaknesses of all the line items of the statement and also to forecast the net profit for the upcoming fiscal periods in light of the results of the current period and he must have sufficient experience because the last net profit figure shown in the income statement, it may not be an indicator to forecast the future profit of the company because some companies can improve the profit figure shown in the income statement by reducing some line items such as the impaired asset; accounts receivable and investments, or even when there are no provisions for any expected liabilities of the company, on the understanding that these line items are not related to operating activity and are characterized by a high degree of volatility and instability, but the problem appears after a period so that the expected profit figure is significantly higher than future cash flows as a result of the impaired asset such as accounts receivable and the inability to collect and also because of the lack of provisions because the company has liabilities and therefore must be paid. Consequently, the financial analyst should when analyzing and evaluating the company's earning capacity and future cash flows of the company that it focuses on the recurring and permanent income components, and the results of recurring operations and the results of non-recurring operations must be separated to facilitate the forecasting of profits and future cash flows, it is also better for all the estimated line items after the operating profit figure and the profitability ratios analysis helps to identify the extent of the company's ability to generate profits from the funds invested in the different assets and profitability indicators based on the ratio of the value of the company's profits and illustrating the return on invested capital, the return on assets, and the return on equity and profitability analysis helps to evaluate the company's financial performance for previous periods and helps to evaluate current and projected investments by estimating future earning capacity and expected future cash flows

Factors that affect the Profitability Analysis

One of the most important factors affecting the profitability analysis is the definition of income, the extent of income stability, sources of income, revenue trends, the relationship between revenue and expenses, and the cost of sales, and this all measures the quality of income and the continuity of income and the ability of the company to achieve profits and many factors affect the income estimates such as the distribution of income and expense over different accounting periods and also determining the useful life of the assets and the idea of ​​recognizing revenue varies from one group to another such as accountants - auditors- financial analysts - company management - shareholders and each entity of the beneficiaries of the financial statements looks the revenue from a different perspective from the other, and revenue analysis are created because products and markets are different. Consequently, the quantity and value of its sales are different, and the profitability is also different, to know the products with the highest income, the lowest products, the areas of their sale and distribution, the reasons for their fall, and the analysis of the trend percentages is very important when decisions are made by the company’s management. Also, that analysis is useful in the annual estimate of the company's revenues whether the company's net revenue or net profit resulting from its operating operations only or whether the result of a sudden event as a result of the company selling a large amount of its assets

Also important factors in profitability analysis

Interest either the interest on loans and bonds or the interest on financial leasing

Interest rates are analyzed and compared with the average interest rate for similar companies or the price in the market and in general, the interest in general are deducted after the operating profit of the company

Income tax, which is a very important line item in the profitability analysis and the income statement due to temporary and permanent differences in tax - deferred tax - which is the accrual accounting and tax accrual and its impact on the net profit and there are other factors that affect the profitability analysis such as

- Changes in accounting principles and accounting policies

- Changes in accounting estimates

- Changes in corporate entity prepared for the financial statements

Revenue Recognition Methods

It is considered an important factor to be taken into account when analyzing profitability and when is revenue recognized, is it when goods or services are converted into cash or when obtaining in exchange for this good is confirmed and their price is collected in the sense of the transfer of risks and benefits associated with ownership of the goods from the seller to the buyer or when the goods or services are converted into assets convertible into cash

There are methods for recognizing revenue, such as the percentage of completion in long-term construction contracts, the installment sales method, and the cost recovery method

Company Sales Analysis

One of the most important things that a financial analyst should analyze is sales and must be analyzed properly including all matters related to sales in terms of sales analysis and how much does the cash sales percentage and the credit sales percentage to total item sales, sales of major customers and the percent of sales of each product to the total item sales, as well as sales analysis by periods and geographical areas, as well as analyzing the percent sales growth over similar periods and the sales growth in terms of sales quantities for each type of product and also the sales value for each type of product

Cost of Sales Analysis

The cost of sales is the most important and largest cost of any company and it has a big and important factor in the profitability of the company, the percentage of increase or decrease in the cost of sales must be analyzed with the percentage of increase or decrease in sales and find out the reasons for the difference, if there is an increase in the percentage of the cost of sales compared to the percentage of increase in sales and know the reason is the company changed the issuance from warehouses policy, or there was a huge increase in the prices of raw materials and purchases, or there was an increase in manufacturing overhead, therefore, the reason must be analyzed and found out, and whether the company can reduce its costs to a minimum so that the gross profit margin and the analysis of the cost of sales are important factors that the financial analyst and the financial manager should analyze them properly and know the reason for the high cost of sales during the period by analyzing the line items of manufacturing costs, especially the main raw materials for the production, as well as analyzing manufacturing costs during the period with all its line items and details, including depreciation, and it must be analyzed because it is the depreciation of machinery and equipment, the production, in general, is included in the cost of sales and therefore the gross profit figure varies, and the depreciation is included in the general expenses and selling expenses and affects the operating profit figure, as well as the useful life of fixed assets, as well as the depreciation method and repairs and maintenance expenses of the important factors that are taken into account when analyzing the profitability of the company

And here comes the role of a financial analyst in presenting proposals regarding to reduce the cost of sales within the appropriate, also, when analyzing the cost of sales, the relative weight of each of the line items, whether inventory line items or manufacturing costs line items, controlling and monitoring in light of the company's budget and analyzing the ratio of the total cost of sale and also the ratio of the cost of sales of each item to the total cost of the items, as well as analyzing the ratio of the cost of sales of each item to the sales of this item to judge well on the profitability or loss of this item and these sub-analysis enables the company’s management to judge well on the product profitability

Gross Profit Margin

= Gross Profit ÷ Total Revenue

Gross Profit = Revenue − Cost of Goods Sold

This ratio or indicator measures the proportion of revenue left after accounting for production costs. It illustrates how much profit a company earns about each pound spent on production

This gross profit margin is affected by different factors such as

- Change in sales volume because it will affect the cost of goods sold and sales revenue

- Change prices of the products or services provided by the company

- Changes in production cost or the purchase cost of products and services that affect the cost of goods

Therefore, the gross profit margin of the company is analyzed properly, and it is imperative that the growth of the indicator is examined during several periods and the trend of the indicator is monitored to rise or fall and the reasons for this to occur is examined and also comparing it with the same percentage other similar companies and with the industry average

Operating Profit Margin

= Earnings Before Interest and Taxes (EBIT) ÷ Total Revenue

This indicator or ratio measures how much profit a company makes on a pounds of sales after deducting costs of production and operating expenses

The gross profit margin was after deducting production costs only, but the operating profit margin was after deducting production costs in addition to operating expenses (selling and administrative expenses)

Earnings Before Interest and Taxes (EBIT) = Revenue – Production Costs – Operating Expenses

The factors that affect operating profit are the extent to which the gross profit margin percentage rise or fall with all the factors affecting it in sales and cost of sales

But other factors affect the quality of operating profit such as the administrative expenses and marketing expenses by all the line items of these expenses and must be analyzed at the level of each line item to the total line items and also analyzed to the ratio of net sales and find out the reasons for the rise or fall of these percentages of expenses and by that, we can analyze the operating profit figure

And comparing this figure with previous periods and find out the reasons for the rise or fall, if any

Net Profit Margin = 

Earnings After Taxes (EAT) ÷ Net Sales

Of course, Earnings After Taxes (EAT) 

= Net Sales – Cost of Goods Sold (COGS) – Operating Expenses – Interest – Taxes

Operating Expenses are often divided into two categories: Marketing Expenses and Administrative Expenses

This ratio indicates how much profit you make on every pound of revenue after deducting all costs of sales, operating expenses, and financing costs

Analyzing corporate profit margin trends by comparing it through several periods similar to the company and also compared it with the same indicator for other companies in the same industry

This is to determine how upwards or downwards the ratio and the rise or fall of the net profit margin is closely related to the operating profit margin ratio, and also the gross profit margin in addition to other factors such as the value of set provisions and an impaired asset, also, finance interest, capital gains/losses, gains or losses on the  sale and valuation of financial investment, etc. and currency valuation differences, and the tax rate in this fiscal period, and whether it is the same rate in the previous the subject of comparison

All line items after operating profit or operating loss must be analyzed properly and comparing these line items to previous periods, knowing that some of these line items are estimated such as provisions and impaired asset, and therefore the financial analyst must take into account that these estimates are appropriate and reliable