Investing Lesson 4 - Printable Version

Investing Lesson 4 - Printable Version http://beginnersinvest.about.com/library/lessons/nlesson4.
htm
Investing for Beginners
Investing Lesson 4: Analyzing an Income

Statement
Introduction
The primary objective of the income statement is to report to

investors how much money a business made or lost during a specific
period of time. Years ago, it was referred to as the Profit and Loss
(or P&L) statement, and has since evolved into the most well-known
and widely used financial report on Wall Street. Many times,
investors make decisions based entirely on the P&L report without
consulting the balance sheet or cash flow statements (which, while
a mistake, is a testament to how influential it is).
To an enterprising investor, the income statement reveals much

more than a business’ earnings. It can give important insights into
how effectively management is controlling costs, how much is being
spent on research and development, the total amount of taxes paid,
and interest coverage. In a few short minutes, an investor or
analyst can also calculate profit and operating margins to compare a
company to its competitors.
As we progress through this series of investing lessons, you must

remember John Burr William’s basic truth that a business is only
worth the profit that it will generate for its owners from now until
doomsday, discounted back to the present, adjusted for inflation.
The income statement is the “report card” of those earnings, which
ultimately determine the price you should be willing to pay for a
business.
Sit back in your chair, take out a copy of an annual report, and let’s
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Investing Lesson 4 - Printable Version http://beginnersinvest.about.com/library/lessons/nlesson4.htm
begin working through it. In the end, I think you’ll be surprised by

how much you’ve learned. As always, there will be quiz following
the lesson; you should be able to pass without missing more than
two questions.
Below is a sample income statement taken from Walt Disney’s 2001

annual report.
It’s important to note that not all income statements look alike,
although they necessarily contain much of the same information. As
we work our way through various income statements, you will
inevitably find they are much simpler and comparable than may
appear at first glance.
Total Revenue or Total Sales

The first line on any income statement is an entry called total
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revenue or total sales. This figure is the amount of money a

business brought in during the time period covered by the income
statement. It has nothing to do with profit. If you owned a pizza
parlor and sold 10 pizzas for $10 each, you would record $100 of
revenue regardless of your profit or loss.
The revenue figure is important because a business must bring in

money to turn a profit. If a company has less revenue, all else being
equal, it’s going to make less money. For startup companies and
new ventures that have yet to turn a profit, revenue can sometimes
serve as a gauge of potential profitability in the future.
Many companies break revenue or sales up into categories to clarify

how much was generated by each division. Clearly defined and
separate revenues sources can make analyzing an income
statement much easier. It allows more accurate predictions on
future growth. Starbucks’ 2001 income statement is an excellent
example:
Starbucks Coffee
Consolidated Statement of Earnings – Excerpt
Page 29, 2001 Annual Report
In thousands except earnings per share
Fiscal year ended Sep 30, 2001 Oct 1, 2000
Net Revenues
Retail $2,229,594 $1,823,607
Specialty 419,386 354,007
Total net revenues 2,648,980 2,177,614
Starbucks’ sales come primarily from two sources: retail and

specialty. In the annual report, management explains the difference
between the two several pages before the income statement.
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“Retail” revenues refer to sales made at company-owned Starbucks

stores across the world. Every time you walk in and order your
favorite latte, you are adding $3-5 in revenue to the company’s
books. “Specialty” operations, on the other hand, are money the
company brings in by sales to “wholesale accounts and licensees,
royalty and license fee income and sales through its direct-
to-consumer business”. In other words, the specialty division
includes money the business receives from coffee sales made
directly to customers through its website or catalog, along with
licensing fees generated by companies such as Barnes and Nobles,
which pay for the right to operate Starbucks locations in their
bookstores.
Cost of Revenue, Cost of Sales, Cost of Goods Sold (COGS)

Cost of goods sold (COGS for short) is the expense a company
incurred in order to manufacture, create, or sell a product. It
includes the purchase price of the raw material as well as the
expenses of turning it into a product. Cost of goods sold is also
known as cost of revenue or cost of sales.
Going back to our Pizza Parlor example, your cost of goods sold
include the amount of money you spent purchasing items such as
flour and tomato sauce.
Gross Profit
The gross profit is the total revenue subtracted by the cost of
generating that revenue. It tells you how much money the business
would have made if it didn’t pay any other expenses such as salary,
income taxes, etc. Gross Profit should be broken out and clearly
labeled on the income statement. Here’s the formula to calculate it
yourself:
Total Revenue - Cost of Goods Sold (COGS) = Gross Profit
The gross profit figure is important because it is used to calculate

something called gross margin, which we will discuss in a moment.
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Gross Profit Margin

Although we are only a few lines into the income statement, we can
already calculate our first ratio. The gross profit margin is a
measurement of a company’s manufacturing and distribution
efficiency. A company that boasts a higher percentage than its
competitors and industry is more efficient. Investors tend to pay
more for businesses that have higher efficiency ratings than their
competitors.
To calculate gross margin, use this formula:
Gross Profit
----------(divided by)----------
Total Revenue
For illustration purposes, let’s calculate the gross margin of

Greenwich Golf Supply (a fictional company).
Greenwich Golf Supply

Consolidated Statement of Earnings – Excerpt
In thousands except earnings per share
Fiscal year ended Sep 30, 2001 Oct 1, 2000
Total Revenue $405,209 $315,000
Cost of Sales $243,125 $189,000
Gross Profit $162,084 $126,000
Assume the average golf supply company has a gross margin of

30%. [You can find this sort of industry-wide information in various
financial publications, online finance sites such as
moneycentral.com, or rating agencies such as Standard and Poors].
We can take the numbers from Greenwich Golf Supply’s income

statement and plug them into our formula:
$162,084 gross profit
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----------(divided by)----------
$405,209 total revenue
The answer, .40 [or 40%], tells us that Greenwich is much more
efficient in the production and distribution of its product than most
of its competitors.
The gross margin tends to remain stable over time. Significant

fluctuations can be a potential sign of fraud or accounting
irregularities. If you are analyzing the income statement of a
business and gross margin has historically averaged around 3-4%,
and suddenly it shoots upwards of 25%, you should be seriously
concerned. For more information on warning signs of accounting
fraud, I recommend Howard Schilit’s Financial Shenanigans: 2nd
edition: How to Detect Accounting Gimmicks and Fraud in Financial
Reports .
Putting It Together Thus Far:

We’ve actually covered a lot of ground. Here’s an example to help
reiterate and / or clarify everything we’ve discussed.
If the owner of an ice cream parlor purchased 10 gallons of vanilla
ice cream for $2 per gallon, and sold each of those gallons to her
customers for $5, the first three lines on her income statement
would look something like this:
Total Revenue $50

(The total revenue is the amount of money rung up at the cash
register. The owner sold 10 gallons of vanilla ice cream to her
customers for $5 per gallon. 10 gallons x $5 a gallon = $50.)
Cost of Revenue $20

(The cost of goods sold was 10 gallons x $2 per gallon = $20)
Gross Profit $30

(The total revenue subtracted by the cost to earn that revenue is
$30. Before taxes, and other expenses, this is the ice cream parlor’s
gross profit.)
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Gross Margin: .6 (or 60%)
Operating Expenses
The next section of the income statement focuses on the operating
expenses that arise during the ordinary course of running a
business. Operating expenses consist of salaries paid to employees,
research and development costs, and other misc. charges that must
be subtracted from the company’s income. As an investor / owner,
you want to work with managements that strive to keep operating
expenses as low as possible while not damaging the underlying
business.
Research and Development

R&D costs can range from nothing to billions of dollars, depending
upon the type of business you are analyzing. Unlike many other
costs (such as income taxes), management is almost entirely free to
decide how should be spent. In 2001, Eli Lilly, one of the world’s
largest pharmaceutical companies, plowed nearly 26% of the total
gross profit back into R&D.
How much should a company spend on R&D? It depends. In highly

creative and fast-moving industries, the amount of money spent on
the research and development budget can literally determine the
future of the business. If Eli Lilly stopped funding the development
of new drugs, its future profitability would suffer, causing a perhaps
permanent decline in earnings. In such cases, it may be appropriate
to compare the level of R&D funding to profitability over time, as
well as to the percentage of gross profit competitors spend on
research and development.
Selling General and Administrative Expenses (SG&A)

SG&A expenses consist of the combined payroll costs (salaries,
commissions, and travel expenses of executives, sales people and
employees), and advertising expenses a company incurs. High
SG&A expenses can be a serious problem for almost any business. A
good management will often attempt to keep SG&A expenses
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limited to a certain percentage of revenue. This can be

accomplished through cost-cutting initiatives and employee lay-offs.
There have been several cases in the past where bloated selling,
general and administrative expenses have literally cost shareholders
billions in profit. In the 1980’s, ABC (later merged with CAP Cities,
then bought by Disney) was spending $60,000 a year on florists, as
well as providing stretch limos and private dining rooms for its
executives. It was the shareholders who were footing the bill. [On a
related note: at the same time these ABC executives were
squandering shareholders’ capital, they were artificially padding
earnings by selling original Jackson Pollack and Willem de Kooning
paintings the network owned!]
Goodwill and other Intangible Asset Amortization Charges

In the past, companies were required to charge a portion of goodwill
to the income statement, reducing reported earnings. For all good
purposes, these charges were ignored by the investor. In June 2001,
the Financial Accounting Standards Board (FASB) [the folks who
make accounting rules in the United States], changed the
guidelines, no longer requiring companies to take these
amortization charges. If the company, through cash-flow analysis
and other means, determines that the goodwill is impaired
[meaning it’s not worth the value it’s carried at on the balance
sheet], management will announce a write-down and reducing the
carrying value of the goodwill. Intangible assets that do not have
indefinite lives [such as patents] will continue to be amortized.
The complexities of goodwill were explained in detail in the Goodwill

section of Lesson 3: Part 23.
Non-Recurring and Extraordinary Items or Events

In the unpredictable world of business, events will arise that are not
expected and most likely not occur again. These one-time events
are separated on the income statement and classified as either
non-recurring or extraordinary. This allows investors to more
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accurately predict future earnings. If, for instance, you were

considering purchasing a gas station, you would base your valuation
on the earning power of the business, ignoring one-time costs such
as replacing the station’s windows after a thunderstorm. Likewise, if
the owner of the station had sold a vintage Coke machine for
$17,000 the year before, you would not include it in your valuation
because you had no reason to expect that profit would be realized
again in the future.
What is the difference between non-recurring and extraordinary

events? A nonrecurring charge is a one-time charge that the
company doesn’t expect to encounter again. An extraordinary item
is an event that materially* affected a company’s finance and needs
to be thoroughly explained in the annual report or SEC filings.
Extraordinary events can include costs associated with a merger, or
the expense of implementing a new production system [as
McDonald’s did in the late 1990’s with the Made for You food
preparation system].
Non-recurring items are recorded under operating expenses, while

extraordinary items are listed after the net line, after-tax.
*The term material is not specific. It generally refers to anything

that affects a company in a meaningful and significant way. Some
investors try to put a number on the figure, saying an event is
material if it causes a change of 5% or more in the company’s
finances.
Accounting for Extraordinary and Non-Recurring Items or

Events in Your Analysis
When calculating a company’s earning-power, it is best to leave
one-time events out of the equation. These events are not expected
to repeat in the future, and doing so will give you a better idea of
the earning power of the company.
If you are attempting to measure how profitable a business has

been over a longer period, say five or ten years, you should average
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in the one-time events to paint a more accurate picture. For

example, if a company purchased a building for $1 in 1990, and sold
it for $10 ten years later in 2000, it is improper to consider the
company earned $10 extra in the year 2000. Instead, the
extraordinary income [in this case, $10], should be divided by the
number of years it accrued [10 years – 1990 to 2000]. $10
extraordinary income divided by 10 years = $1 a year.
Although the income statement will reflect a $10 one-time profit for
the business, the investor should restate the earnings during their
analysis by going back and adding $1 to each of the years between
1990 and 2000. This will increase the accuracy of a trend line. Since
the asset was quietly appreciating during this time, it should be
reflected.
Operating Income
Operating income, or operating profit, is a measurement of the
money a company generated from its own operations [it doesn’t
include income from investments in other businesses, for instance].
Operating income can be used to gauge the general health of the
core business or businesses.
Operating Income = gross profit – operating expenses
The operating income figure is tremendously important because it is

required to calculate the interest coverage ratio and the operating
margin
Operating Margin [or Operating Profit Margin]

The operating margin is another measurement of management’s
efficiency. It compares the quality of a company’s operations to its
competitors. A business that has a higher operating margin than its
industry’s average tends to have lower fixed costs and a better
gross margin, which gives management more flexibility in
determining prices. This pricing flexibility provides an added
measure of safety during tough economic times.
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To calculate the operating margin, divide operating income by the

total revenue.
Operating income
----------(divided by)----------
Total revenue
Interest Income
Companies sometimes keep their cash hoards in short-term deposit
investments [such as certificates or deposit with maturities up to
twelve months, savings account, and money market funds]. The
cash placed in these accounts earn interest for the business, which
is recorded on the income statement as interest income.
Interest income will fluctuate each year with the amount of cash a
company keeps on hand.
Interest Expense
Companies often borrow money in order to build plants or offices,
buy other businesses, purchase inventory, or fund day-to-day
operations. The borrowed money is converted to an asset on the
balance sheet (i.e., if a business borrows $1 million to build a
distribution center, the distribution center would add $1 million of
assets to the balance sheet after the cash was spent.) The interest a
company pays to bondholders, banks, and private lenders, on the
other hand, is an expense that it receives no asset for. Hence,
interest expense must be accounted for on the income statement.
Some income statements report interest income and interest

expense separately, while others report interest expense as “net”.
Net refers to the fact that management has simply subtracted
interest income from interest expense to come up with one figure.
[In other words, if a company paid $20 in interest on its bank loans,
and earned $5 in interest from its savings account, the income
statement would only show interest expense – net $15.]
The amount of interest a company pays in relation to its revenue
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and earnings is tremendously important. To gauge the relation of

interest to earnings, investors can calculate the interest coverage
ratio.
Interest Coverage Ratio

The interest coverage ratio is a measurement of the number of
times a company could make its interest payments with its earnings
before interest and taxes; the lower the ratio, the higher the
company’s debt burden.
Interest coverage is the equivalent of a person taking the combined

interest expense from their mortgage, credit cards, auto and
education loans, and calculating the number of times they can pay it
with their annual pre-tax income. For bond holders, the interest
coverage ratio is supposed to act as a safety gauge. It gives you a
sense of how far a company’s earnings can fall before it will start
defaulting on its bond payments. For stockholders, the interest
coverage ratio is important because it gives a clear picture of the
short-term financial health of a business.
To calculate the interest coverage ratio, divide EBIT (earnings

before interest and taxes) by the total interest expense.
EBIT (earnings before interest and taxes)

-----------------------(divided by)-----------------------
Interest Expense
As a general rule of thumb, investors should not own a stock that

has an interest coverage ratio under 1.5. A ratio below 1.0 indicates
the business is having difficulties generating the cash necessary to
pay its interest obligations. The history and consistency of earnings
is tremendously important. The more consistent a company’s
earnings, the lower the interest coverage ratio can be.
EBIT has its short fallings; companies do pay taxes, therefore it is

misleading to act as if they didn’t. A wise and conservative investor
would simply take the company’s earnings before interest and
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divide it by the interest expense. This would provide a more

accurate picture of safety.
Depreciation and Amortization

There are two different kinds of “depreciation” an investor must
grapple with when analyzing financial statements, accumulated
depreciation and depreciation expense. They are entirely different
things, and are often confused with one another. In order to
understand them, we must discuss them individually.
Depreciation Expense
According to Ameritrade, “Depreciation is the process by which a

company gradually records the loss in value of a fixed asset. The
purpose of recording depreciation as an expense over a period is to
spread the initial purchase price of the fixed asset over its useful
life. [emphasis added] Each time a company prepares its financial
statements, it records a depreciation expense to allocate the loss in
value of the machines, equipment or cars it has purchased.
However, unlike other expenses, depreciation expense is a
"non-cash" charge. This simply means that no money is actually
paid at the time in which the expense is incurred.”
To help you understand the concept, let’s look at an example:
Sherry’s Cotton Candy Co., earns $10,000 profit a year. In the

middle of 2002, the business purchases a $7,500 cotton candy
machine that is expected to last for five years. If an investor
examined the financial statements, they might be discouraged to
see that the business only made $2,500 at the end of 2002 [$10k
profit - $7.5k expense for purchasing the new machinery]. The
investor would wonder why the profits had fallen so much during the
year.
Thankfully, Sherry’s accountants come to her rescue and tell her

that the $7,500 must be allocated over the entire period it is going
to benefit the company. Since the cotton candy machine is expected
to last five years, Sherry can take the cost of the cotton candy
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machine and divide it by five [$7,500 / 5 years = $1,500 per year].

Instead of realizing a one-time expense, the company can subtract
$1,500 each year for the next five years, reporting earnings of
$8,500. This allows investors to get a more accurate picture of how
the company’s earning power. The practice of spreading-out the cost
of the asset over its useful life is “depreciation expense”.
This presents an interesting dilemma; although the company

reported earnings of $8500 in the first year, it was still forced to
write a $7,500 check [effectively leaving it with $2500 in the bank
at the end of the year [$10,000 profit - $7,500 cost of machine =
$2,500 left over]. This means that the cash flow of the company is
actually different from what it is reporting in earnings. The
cash-flow is very important to investors because they need to be
ensured that the company can pay its bills on time. The first year,
Sherry’s would report earnings of $8,500, but only have $2,500 in
the bank. Each subsequent year, it would still report earnings of
$8,500, but have $10,000 in the bank since, in reality, the business
paid for the machinery up-front in a lump-sum. Hence, if an investor
knew that Sherry had a $3,000 loan payment due to the bank in the
first year, he may incorrectly assume that the company would be
able to cover it since it reported earnings of $8,500. In reality, the
business would be $500 short.*
This is where the third major financial report, the Cash Flow
Statement, is important. The cash flow statement is like a
company’s checking account. It shows how much cash was spent, at
what time, and where. That way, an investor could look at the
income statement of Sherry’s Cotton Candy Co. and see a profit of
$8,500 each year, then turn around and look at the cash flow
statement and see that the company really spent $7,500 on a
machine this year, leaving it only $2,500 in the bank. The cash flow
statement is the focus of Investing Lesson 5.
Some investors and analysts incorrectly maintain that depreciation

expense should be added back into a company’s profits because it
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requires no immediate cash outlay. In other words, Sherry wasn’t

really paying $1,500 a year, so the company should have added
those back in to the $8,500 in reported earnings and valued the
company based on a $10,000 profit, not the $8,500 figure. This is
incorrect. Depreciation is a very real expense. Depreciation
attempts to match up profit with the expense it took to generate
that profit. This provides the most accurate picture of a company’s
earning power. An investor who ignores the economic reality of
depreciation will be apt to overvalue a business and find his or her
returns lacking.
*Depreciation expenses are deductible; Sherry’s would only pay taxes on $8,500
each year, spreading out her tax burden to the future. Some investors assume
incorrectly that the business would pay taxes on $2,500 the first year and the
full $10,000 each year after.
Accumulated Depreciation
If you purchased a new car for $50,000 and resold it three years
later for $30,000, you would have experienced $20,000 loss on the
value of your asset. This $20,000 is due to a force called
depreciation. Accumulated depreciation is the reduction of the
carrying amount of the assets on the balance sheet to reflect the
loss of value due to wear, tear, and usage. Companies purchase
assets such as computers, copy machines, buildings, and furniture,
all of which lose value each day. This depreciation loss must be
accounted for in the company’s financial statements in order to give
shareholders the most accurate portrayal of the economic realty of
the business.
When you look at a balance sheet, if you see the entry “Property,
Plant, and Equipment – net” it is referring to the fact that the
company has deducted accumulated depreciation from the figure
presented. To see the amount of those depreciation charges, you
will probably have to delve into the annual report or 10k.
Straight Line Depreciation Method

The simplest and most commonly used, straight-line depreciation is
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calculated by taking the purchase or acquisition price of an asset

subtracted by the salvage value divided by the total productive
years the asset can be reasonably expected to benefit the company
[called “useful life” in accounting jargon].
purchase price of asset – approximate salvage value

-------------------------- (divided by) --------------------------
estimated useful life of asset
Example: You buy a new computer for your business costing

approximately $5,000. You expect a salvage value of $200 selling
parts when you dispose of it. Accounting rules allow a maximum
useful life of five years for computers; in the past, your business has
upgraded its hardware every three years, so you think this is a more
realistic estimate of useful life, since you are apt to dispose of the
computer at that time. Using that information, you would plug it
into the formula:
$5,000 purchase price - $200 approximate salvage value

-------------------------- (divided by) --------------------------
3 years estimated useful life
The answer, $1,600, is the depreciation charges your business

would take annually if you were using the straight line method.
Accelerated Depreciation Methods

Another way of accounting for depreciation is to use one of the
accelerated methods. These include the Sum of the Year’s Digits
and the Declining Balance [either 150 or 200%] methods. These
accelerated methods are more conservative and, in most cases,
accurate. They assume that an asset loses a majority of its value in
the first several years of use.
Sum of the Years Digits

To calculate depreciation charges using the sum of the year’s digits
method, take the expected life of an asset (in years) count back to
one and add the figures together. Example:
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10 years useful life = 10 + 9 + 8 + 7 + 6 +5 + 4 + 3 + 2 + 1 Sum

of the years = 55
In the first year, the asset would be depreciated 10/55 in value [the
fraction 10/55 is equal to 18.18%] the first year, 9/55 [16.36%] the
second year, 8/55 [14.54%] the third year, and so on. Going back
to our example from the straight-line discussion: a $5,000 computer
with a $200 salvage value and 3 years useful life would be
calculated as follows:
3 years useful life = 3 + 2 + 1 Sum of the years = 6
Taking $5,000 - $200 we have a depreciable base of $4,800. In the

first year, the computer would be depreciated by 3/6ths [50%], the
second year, by 2/6 [33.33%] and the third and final year by the
remaining 1/6 [16.67%]. This would have translated into
depreciation charges of $2,400 the first year, $1,599.84 the second
year, and $800.16 the third year. The straight-line example would
have simply charged $1,600 each year, distributed evenly over the
three years useful life.
Double Declining Balance Depreciation

The double declining balance depreciation method is like the
straight-line method on steroids. To use it, accountants first
calculate depreciation as if they were using the straight line
method. They then figure out the total percentage of the asset that
is depreciated the first year and double it. Each subsequent year,
that same percentage is multiplied by the remaining balance to be
depreciated. At some point, the value will be lower than the
straight-line charge, at which point, the double declining method
will be scrapped and straight line used for the remainder of the
asset’s life [got all that?]. An illustration may help.
In our straight-line example, we calculated that a $5,000 computer

with a $200 salvage value and an estimated useful life of three
years would be depreciated by $1,600 annually. The first year, we
have to compare this to the total amount to be depreciated, in this
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case, $4,800 [$5,000 base - $200 salvage value = $4,800]. Dividing

$1,600 by $4,800, we discover the straight-line depreciation charge
[$1,600] is 33.33% of the total depreciation amount [$4,800]. Using
this information, we double the 33.33% figure to 66.67%.
In the first year, we would take $4,800 multiplied by .6667 to get a

total depreciation charge of approximately $3,200. In the second
year, we would take the same percentage [66.67%] and multiply it
by the remaining amount to be depreciated. Continuing with the
example, we find that $1,600 is the remaining amount to be
depreciated at the start of the second year [$4,800 - $3,200 =
$1,600]. Multiply 1,600 by .6667 to get $1,066. This is the
depreciation charge for the second year – or not! Remember that
once the depreciation charges dip below the amount that would be
charged using the straight-line method, the double declining
balance is scrapped and straight line immediately utilized. The
straight line method called for charges of $1,600 per year.
Obviously, the $1,066 charge is smaller than the $1,600 that would
have occurred under straight line. Thus, the deprecation charge for
the second year would be $1,600.
For those of you who love algebra, you may find it easier to use this
equation:
depreciable base * (2 * 100% / useful life in years)
Comparing Depreciation Methods

Just to reinforce what we’ve learnt thus far, here’s a look at what
the depreciation charges for the same $5,000 computer would look
like depending upon the method used.
Comparing Depreciation Methods
Method Year 1 Year 2 Year 3
$1,600
Straight Line $1,600 $1,600
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Sum of the Years $2,400 $1599.84 $800.16
$3,200
Double Declining Balance $1,600 $0
Obviously, depending upon which method is used by management,

the bottom-line of a company can be seriously affected. The level of
attention an investor must give depreciation depends upon the asset
intensity of the business he or she is studying. The more asset-
intensive an enterprise, the more attention depreciation should be
given.
If you have two asset intensive businesses, and they are using
different depreciation methods, and / or useful lives, you must
adjust them so they are on a comparable basis in order to get an
accurate picture of how they stack up against each other in terms of
profit.
Some managements will report depreciation expense broken out as

a separate line on the income statement, while others will be more
clandestine about it, including it indirectly through SG&A expenses
[for the deprecation costs of desks, for instance]. Either way, you
should be able to garner the information either through the income
statement itself or going through the annual report or 10k.
In Security Analysis [the classic 1934 edition], Benjamin Graham

recommended the investor answer three questions when dealing
with the effects of deprecation on a business [paraphrased]:
1. Is depreciation reflected in the earnings statement?

2. Is management using conservative and [as much as possible]
accurate depreciation rates? Accounting rules allow assets to be
written off over a considerable time period. Buildings, for example,
can be depreciated anywhere from ten to thirty years, resulting in
large differences in charges depending upon the time frame a
particular business uses. A company’s 10k filing should contain
information on the rates employed by the company.
3. Are the cost or base to which the depreciation rates applied
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reasonable accurate? A company may set unrealistic salvage values

on its assets, thus reducing the amount of depreciation charges it
must take every year.
Earnings Before Interest, Tax, Depreciation and Amortization

- EBITDA
EBITDA tells an investor how much money a company would have
made if it didn’t have to pay interest on its debt, taxes, or take
depreciation and amortization charges. EBITDA is intended to be an
indicator of a company’s financial performance, not free cash flow
as many investor incorrectly assume, originally coming into
existence in the 1980’s during the leveraged-buyout frenzy that
epitomized the era of greed. The measurement has become so
popular that many companies will boast charts and graphs of their
increased EBITDA within the first five pages of their annual report.
Investors, thinking this is wonderful, get excited about the business
because it appears to be growing in leaps and bounds.
In its brilliance, Wall Street regrettably forgot one part of the

equation: common sense. Companies do have to pay interest,
taxes, depreciation, and amortization. Treating these expenses like
they don’t exist is the same mentality of the five year old who
believes no one can see them when their eyes are closed – while
they may enjoy pretending for a while, the IRS and the banks and
bondholders who lent money to the company aren’t interested in
playing games. When the bills come due, these entities want the
money owed to them and can force bankruptcy if they aren’t paid.
Still not convinced? Picture this scenario:
A man making $100,000 annually walks into his local bank to get a
loan on a new BMW. He pays an annual taxes of about $30,000,
leaving his take-home pay at $1346.15 per week [for simplicity
sake, let’s ignore payroll deductions, etc.] He currently has a
mortgage payment of $750 a month, and student loan payments of
$250 a month. After paying out this $1,000 each month, he is left
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with $346.15 to live on
The loan officer crunches the numbers and comes up with an

estimated monthly payment of $400 for the car. The man pulls out
his pen to sign the papers. The loan offer looks in confusion after
reviewing his information. “Sir,” she says, “you only make $346.15
a month after payments and taxes! You can’t afford this loan. Not
only can you not afford the payment, you will then have nothing to
live on.” The man looks confused, “but I make $1,346.15 per month
before my payments and taxes.”
See the fallacy? The gentlemen in our example may ignore the
loans, but his creditors surely aren’t. In fact, the officer would
probably laugh at him. Sadly, this is exactly what corporations are
doing by presenting their EBITDA numbers to investors.
The truth is, in virtually all cases, EBITDA is absolutely, entirely,

and utterly useless. It is simply a way for companies that can’t
make money to dress-up their failures by reporting increased
something to investors. When the traditional metric of profit
couldn’t be attained, they created a new one that made them
appear successful.
In the accounting and business world, EBITDA is a firestorm of

controversy. There are some who will defend it vehemently, and
attempt to ridicule you for even suggesting it isn’t worth the time it
takes to pronounce the letters. Often, these people will appear to be
very intelligent, driven, and professional. Don’t worry about it – four
hundred years ago, the brightest men on earth thought the world
was flat. Smile and say a prayer of thanks because it’s folly such as
this that presents us with opportunity to profit in the market.
If you are interested, there is an excellent article at the Motley

Fool’s website called The Limits of EBITDA. I highly recommend it.
Additional information:
10 Critical Failing of EBITDA - Computer World
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EBITDA: The Good, the Bad, and The Ugly – Investopedia

Ignore EBITDA - The Motley Fool
What is EBITDA - The Motley Fool
Income before Tax

After deducting interest payments and [depending on the business]
other expenses, the analyst / investor is left with the profit a
company made before paying its income tax bill. It allows you to
see what the business would have earned if it did not have to pay
taxes to the government.
Income Tax Expense

The income tax expense is the total amount the company paid in
taxes. This figure is frequently broken out by source [federal, state,
etc.] either on the income statement or somewhere in the annual
report or 10k.
You should be fairly familiar with the tax laws affecting specific
companies and / or business transactions. For instance, say the
business you were analyzing just purchased $100 million worth of
preferred stock that was paying a 9% yield [we’ll talk more about
preferred stock later]. You could rightly assume the company would
receive $9 million a year in dividends on the preferred. If the
company had a tax rate of, say, 35%, you may assume that $3.15
million of these dividends are going to be paid to the Uncle Sam. In
truth, corporations get an exemption on 70% of the dividends they
receive from preferred stock [individuals do not enjoy this luxury].
Hence, only $2.7 million of the $9 million in dividends would be
subject to taxation. Don’t you love this stuff?
For your reference, here is a list of the corporate tax brackets from
smbiz.com. It would serve you well to memorize them:
Corporate Income Tax Rates--2002, 2001, 2000, 1999, & 1998
Taxable income over Not over Tax rate
$ 0 $ 50,000 15%
50,000 75,000 25%
75,000 100,000 34%
100,000 335,000 39%
335,000 10,000,000 34%
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10,000,000 15,000,000 35%

15,000,000 18,333,333 38%
18,333,333 .......... 35%
Minority Interests on the Income Statement

If Federated Department Stores [the owner of Macy’s and
Bloomingdales] purchased five percent of Saks Fifth Avenue, Inc.,
common sense tells us that Federated would be entitled to five
percent of Saks’ earnings. How would Federated report their share
of Saks’ earnings on their income statement? It depends on the
percentage of the company’s voting stock Federated owned.
• Cost Method (If Federated owned 20% or less):

The company would not be able to report its share of Saks’
earnings, except for the dividends it received from the Saks stock.
The asset value of the investment would be reported at the lower of
cost or market value on the balance sheet. What does that mean?
If Federated purchased 10 million shares of Saks stock at $5 per

share [for a total cost of $50 million], it would record any dividends
received on its income statement, and add $50 million to the
balance sheet under investments. If Saks rose to $10 per share, the
10 million shares would be worth $100 million [$10 per share x 10
million shares = $100 million]. However, the balance sheet would
continue to list the ‘value’ of those 10 million shares at $50 million.
On the other hand, if the stock dropped to $2.50 per share, thus
reducing the investments to $25 million, the balance sheet value
would be written down to reflect the lower price.
• Equity Method (If Federated owned 21-49%):

In most cases, Federated would include a single-entry line on their
income statement reporting their share of Saks’ earnings. For
example, if Saks earned $100 million and Federated owned 30
percent, they would include a line on the income statement for $30
million in income [30% of $100 million], even if these earnings were
never paid out as dividends [meaning they never actually saw $30
million].
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• Consolidated Method (If Federated owned 50+%):

The company would be required to include all of the revenues,
expenses, tax liabilities, and profits of Saks on the income
statement. It would then include an entry that deducted the
percentage of the business it didn’t own. If Federated owned 65% of
Saks, it would report the entire $100 million in profit, and then
include an entry labeled minority interest that deducted the $35
million [35%] of the profits it didn’t own.
The Importance of Unreported or Look Through Earnings

You’ll notice that the cost method, which applies to holdings under
20%, only allows the company to report the cash it actually receives
in the form of dividends as income. This can be misleading. If your
company owned 15% of Microsoft, you would never see a dime in
dividends, although your 15% share of the earnings was being
reinvested in the business on your behalf by management. Those
earnings will subsequently lead to long-term rise in the value of
your stock holding, and are therefore very important to your
economic future.
Don’t believe it? Say you inherit a business that your great-
grandfather founded a century ago. At the end of every year, he
used some of the business’ profits to buy shares of Thomas Edison’s
company, General Electric. By the time the company came under
your control in 2002, it owned 19% of GE’s common stock
[1,888,600,000 shares]. General Electric paid a dividend that year
of $0.72 per share. According to GAAP accounting rules, your
business could only report the $1,359,792,000 in dividends you
received.
However, the year before, General Electric had actually made a

profit of $14.6 billion, of which, nineteen percent indirectly belonged
to you. Although you could only report $1.36 billion in dividends,
you actually have a legal ownership to $2.774 billion in the
company’s earnings ($1.36 billion were paid out to you as
dividends, with the remaining $1.4 billion retained by GE). This
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means that you were not allowed to report more than $1.4 billion in
earnings that indirectly belonged to you. The general logic states
that because you never see that money, it shouldn’t count as
income. This is both misinformed and dangerous. The entire $2.774
billion belongs to you. The portion of the earnings that were not
paid out will be reinvested into GE’s business and subsequently
result in a rise in the stock price. If someone were to value the
business, they would include the entire $2.774 billion in their
calculation because the entire amount was working to your
economic benefit.
Famed investor Warren Buffett referred to these unreported profits

as look-through earnings. The successful investor strives to put
together a portfolio with the highest possible look-through earnings
for each dollar invested. This will result in market-beating returns.
In his 1980 Letter to Shareholders of Berkshire Hathaway, Buffett
explained that Berkshire’s income statement was reporting less than
half of what the company’s true economic earnings were:
“Our holdings in this [20% or less] category of companies [has]

increased dramatically in recent years as our insurance business has
prospered and as securities markets have presented particularly
attractive opportunities in the common stock area. The large
increase in such holdings, plus the growth of earnings experienced
by those partially-owned companies, has produced an unusual
result; the part of ‘our’ earnings that these companies retained last
year (the part not paid to us in dividends) exceeded the total
reported annual operating earnings of Berkshire Hathaway. Thus,
conventional accounting only allows less than half of our earnings
“iceberg” to appear above the surface, in plain view.”
Thus, you must add the non-reportable earnings of a company’s

partially owned businesses back into the income statement to come
up with an accurate estimate of economic earnings.
Continuing / Ongoing Operations vs. Discontinued
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Operations
In the 1990’s, Viacom, owner of MTV, VH1, and Nickelodeon,
purchased Paramount Studios. To pay for the acquisition, Viacom
took on a large amount of debt. The company’s Chairman, Sumner
Redstone, began selling assets and businesses the company owned
in order to help pay down debt.
Simon & Schuster, a major book publisher, was one of the

businesses Viacom decided to let go, ultimately selling it to British
media group Pearson PLC for $4.6 billion dollars. How did the deal
affect the company’s revenue and earnings?
This is where discontinued and ongoing operations come to the

rescue. As soon as Viacom sold Simon, it had a pile of cash from the
buyer. However, it lost all of the revenue and profit the publisher
generated. Viacom’s management must somehow warn investors,
“Hey, Simon generated [X amount] of our profit and revenue. Since
we no longer own the business, you can’t plan on us earning this
revenue / profit next year”. To do that, the Viacom puts an entry on
their income statement called “Discontinued Operations”. This
shows investors money that was earned from businesses that won’t
be part of the company’s holdings for very much longer.
Continuing operations are the businesses the company expects to be

engaged in for the foreseeable future.
Net Income from Continuing Operations

After all of these expenses are deducted, the investor is left with a
figure called net income from continuing operations. This is a
calculation of the profit its continuing operations generated during
the period.
Net Income from Discontinued Operations

The amount shown on the income statement under discontinued
operations is the profit made during the period from the businesses
that will not be a part of the company in the future.
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Accounting Changes
GAAP accounting rules give management a large amount of leeway
in determining how to report their earnings to shareholders. At
times, a company may opt to change the way it has accounted for a
particular item in the past, which will have the affect of increasing
or decreasing the amount of reportable earnings although the
company has not actually made or lost more money.
Management is required to disclose accounting changes in SEC

filings. It is tremendously important that you determine if the
change was necessary or simply a maneuver to inflate the amount
of profit reported to shareholders.
Net Income
The net income is the total profit the business made for the period
before required dividend payments on the company’s preferred
stock.
Preferred Stock and Other Adjustments

Preferred stock is a mix between regular common stock and a bond.
Each share of preferred stock is normally paid a guaranteed,
relatively high dividend and has first dibs over common stock at the
company's assets in the event of bankruptcy. In exchange for the
higher income and safety, preferred shareholders miss out on large
potential capital gains [or losses]. Owners of preferred stock
generally do not have voting privileges.
The terms of preferred shares can vary widely, even when issued by
the same company. Some of the many different kinds of preferred
stock available are: adjustable rate preferred stock, convertible
preferred stock, first preferred stock, participating preferred stock,
participating convertible preferred stock, prior preferred stock, and
second preferred stock. [For more information, read the remainder
of 09/16/02 article Preferred Stock and Individual Investors].
The dividends paid to preferred shares are deducted as an expense

because they are required payments, unlike the common stock
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dividend which is just a divvying-up part of the profits.
Net Income Applicable to Common Shares

The net income applicable to common shares figure is the
bottom-line profit the company reported. To get the basic earnings-
per-share [Basic EPS] figure, analysts divide the net income
applicable to common by the total number of shares outstanding.
The last line, at the bottom of the income statement is the amount
of money the company purports to have made (net income, total
profit, or reportable earnings; it’s all the same). Hence the cliché,
“what’s the bottom line?”
Net Profit Margin

The profit margin tells you how much profit a company makes for
every $1 it generates in revenue. Profit margins vary by industry,
but all else being equal, the higher a company’s profit margin
compared to its competitors, the better. Several financial books,
sites, and resources tell an investor to take the after-tax net profit
divided by sales. While this is standard and generally accepted,
some analysts prefer to add minority interest back into the
equation, to give an idea of how much money the company made
before paying out to minority “owners”. Either way is acceptable,
although you must be consistent in your calculations. All companies
must be compared on the same basis.
Option 1: Net income after taxes

-------------------------- (divided by) --------------------------
Revenue
Option 2: Net income + minority interest + tax-adjusted interest

-------------------------- (divided by) --------------------------
Revenue
In some cases, lower profit margins represent a pricing strategy.

Some businesses, especially retailers, may be known for their
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low-cost, high-volume approach. In other cases, a low net profit

margin may represent a price war which is lowering profits, as was
the case in the computer industry in 2000.
Net Profit Margin Example

In 2002, Donna Manufacturing sold 100,000 widgets for $5 each,
with a COGS of $2 each. It had $150,000 in operating expenses,
and paid $52,500 in taxes. What is the net profit margin?
First, we need to find the revenue or total sales. If Donna's sold

100,000 widgets at $5 each, it generated a total of $500,000 in
revenue. The company's cost of goods sold was $2 per widget;
100,000 widgets at $2 each is equal to $200,000 in costs. This
leaves a gross profit of $300,000 [$500k revenue - $200k COGS].
Subtracting $150,000 in operating expenses from the $300,000
gross profit leaves us with $150,000 income before taxes.
Subtracting the tax bill of $52,500, we are left with a net profit of
$97,500.
Plugging this information into our formula, we get:
$97,500 net profit

--------------(divided by)--------------
$500,000 revenue
The answer, 0.195 [or 19.5%], is the net profit margin. Keep in
mind, when you perform this calculation on an actual income
statement, you will already have all of the variables calculated for
you; your only job is to plug them into the formula. [Why then did I
make you go to all the work? I just wanted to make sure you've
retained everything we've talked about thus far!]
Cherry Pie: Basic vs. Diluted Earnings per Share

When you analyze a company, you have to do it on two levels, the
“whole company” and the “per share”. If you decide ABC, Inc. is
worth $5 billion as a whole, you should be able to break it down by
simply dividing the $5 billion price tag by the number of shares
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outstanding. Unfortunately, it isn’t always that simple.
Think of each business you analyze as a cherry pie and each share
of stock as a piece of that pie. All of the company’s assets,
liabilities, and profits are represented by the pie as a whole. ABC’s
pie is worth $5 billion. If the baker [management] slices the pie into
5 pieces, each piece would be worth $1 billion [$5 billion pie divided
into 5 pieces = $1 billion per slice]. Obviously, any intelligent
connoisseur of pastries would want to keep the baker from making
too many slices so his or her piece was as big as possible. Likewise,
an ambitious investor hungry for returns is going to want to keep
the company from increasing the number of shares outstanding.
Every new share management issues decreases the investor’s
“piece” of the assets and profits a tiny bit. Over time, this can make
a huge difference in how much the investor gets to eat.
“How can management increase the number of shares outstanding?”

you may ask. There are four big knives [perhaps “cleavers” would
be a more appropriate term] in any management’s drawer that can
be used to add increase the number of shares outstanding: stock
options, warrants, convertible preferred stock, and secondary equity
offerings [all sound more complicated than they are]. Stock options
are a form of compensation that management often gives to
executives, managers, and in some cases, regular employees.
These options give the holder the right to buy a certain number of
shares by a specific date at a specific price. If the shares are
“exercised” the company issues new stock. Likewise, the other three
cleavers have the same affect – the potential to increase the
number of shares outstanding.
This situation leaves Wall Street with the problem of how much to
report for the earnings per share figure. In response, they came up
with two sets of EPS numbers: basic and diluted. The basic figure is
the total earnings per share based on the number of shares
outstanding at the time. The diluted earnings per share figure
reveals how much profit per-share a business would have made if all
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stock options, warrants, convertibles, etc. were invoked and the

additional shares increased the total shares outstanding. The
percentage of a company that is represented by these possible
share dilutions is called “hang”.
Although ABC may have 5 shares outstanding today, it may actually

have the potential for 15 shares outstanding during the next year.
Valuation on a per-share basis should reflect the potential dilution to
each share. Although it is unlikely all of the potential shares will be
issued [the stock market may fall, meaning a lot of executives won’t
exercise the stock options, for example], it is important that you
value the business assuming all possible dilution that can take place
will take place. This practiced conservatism can mean the difference
between mediocre and spectacular returns on your investment.
Below is an excerpt from Intel’s 2001 income statement.
Intel
Excerpt – 2001 Annual Report
Earnings per share from continuing operations 2001 2000
Basic $.19 $1.57
Diluted $.19 $1.51
In 2000, the difference between Intel’s basic and diluted EPS

amounted to around $0.06. If you consider the company has over
6.5 billion shares outstanding, you realize that dilution is taking
more than $390 million in value from current investors and giving it
to management and employees.
Clandestine Boarding on Dishonesty

Some companies don’t include the possible share dilution from
options that are “underwater”. This occurs when an employee owns
options to buy shares at a certain price, and due to a sudden drop in
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stock market value, the option is below the exercise price. If [and
this is a big if], the stock does not rise over the exercise price, the
option will expire worthless. On the other hand, if the stock
advances to higher levels, these options will probably be exercised,
increasing the number of shares outstanding, and dilution your
percentage ownership in the business.
The problem with not including these underwater options in the

diluted figures is that options normally have extended life [in some
cases around 10 years]. In that time, it is very likely if not certain
that some of those options will become valuable once the company’s
stock price rises.
Here’s an example from Abercrombie & Fitch’s 10K:
Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of

Class A Common Stock were outstanding at year-end 2001, 2000
and 1999, respectively, but were not included in the computation of
net income per diluted share because the options’ exercise prices
were greater than the average market price of the underlying
shares.
As you analyze companies, you must keep your eye out for such
border-line deceptive practices as they are widespread and common
occurrence.
Share Repurchase Programs

Just as stock options, warrants, and convertible preferred issues can
dilute your ownership in a company, share repurchase plans can
increase your ownership by reducing the number of shares
outstanding. Below is a reprint of an article I published on June 4,
2001.
Stock Buybacks – The Golden Egg of Shareholder Value

“Overall growth is not nearly as important as growth per share…”
All investors have no doubt heard of corporations authorizing share

buyback programs. Even if you don't know what they are or how
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they work, you at least understand that they are a good thing [in
most situations]. Here are three important truths about these
programs - and most importantly, how they make your portfolio
grow.
Principle 1: Overall Growth is not nearly as important as Growth per

Share
Too often, you'll hear leading financial publications and broadcast

talking about the overall growth rate of a company. While this
number is very important in the long run, it is not the all-important
factor in deciding how fast your equity in the company will grow.
Growth per share is.
A simplified example may help. Let's look at a fictional company:
Eggshell Candies, Inc.

$50 per share
100,000 shares outstanding
-------------------------------------------
Market Capitalization: $5,000,000
This year, the company made a profit of $1 million dollars.

==================================
In this example, each share equals .001% of ownership in the
company. [100% divided by 100,000 shares.]
Management is upset by the company's performance because it sold

the exact same amount of candy this year as it did last year. That
means the growth rate is 0%! The executives want to do something
to make the shareholders money because of the disappointing
performance this year, so one of them suggests a stock buyback
program. The others immediately agree; the company will use the
$1 million profit it made this year to buy stock in itself.
The very next day, the CEO goes and takes the $1 million dollars
out of the bank and buys 20,000 shares of stock in his company.
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[Remember it is trading at $50 a share according to the information

above.] Immediately, he takes them to the Board of Directors, and
they vote to destroy those shares so that they no longer exist. This
means that now there are only 80,000 shares of Eggshell Candies in
existence [instead of the original 100,000].
What does that mean to you? Well, each share you own no longer
represents .001% of the company... it represents .00125% of the
company... that's a 25% increase in value per share! The next day
you wake up and find out that your stock in Eggshell is now worth
$62.50 per share instead of $50. Even though the company didn't
grow this year, you still made a twenty five percent increase on
your investment! This leads to the second principle.
Principle 2: When a company reduces the amount of shares

outstanding, each of your shares becomes more valuable and
represents a greater percentage of equity in the company.
If a shareholder-friendly management such as this one is kept in

place, it is possible that someday there may only be 5 shares of the
company, each worth one million dollars. When putting together
your portfolio, you should seek out businesses that engage in these
sort of pro-shareholder practices and hold on to them as long as the
fundamentals remain sound. One of the best examples is the
Washington Post, which was at one time only $5 to $10 a share. It
has traded as high as $650 in recent months. That is long term
value!
Principle 3: Stock Buybacks are not good if the company pays

too much for its own stock!
Even though buybacks can be huge sources of long-term profit for

investors, they are actually harmful if a company pays more for its
stock than it is worth. In an overpriced market, it would be foolish
for management to purchase equity at all [even in itself].
Instead, the company should put the money into assets that can be
easily converted back into cash. This way, when the market swung
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the other way and is trading below its true value, shares of the
company can be bought back up at a discount - giving shareholders
maximum benefit.
Remember, "even the best investment in the world isn't a good

investment if you pay too much for it".
Return on Equity – ROE

One of the most important profitability metrics is return on equity
[or ROE for short]. Return on equity reveals how much profit a
company earned in comparison to the total amount of shareholder
equity found on the balance sheet. If you think back to lesson three,
you will remember that shareholder equity is equal to total assets
minus total liabilities. It’s what the shareholders “own”. Shareholder
equity is a creation of accounting that represents the assets created
by the retained earnings of the business and the paid-in capital of
the owners.
A business that has a high return on equity is more likely to be one

that is capable of generating cash internally. For the most part, the
higher a company’s return on equity compared to its industry, the
better. This should be obvious to even the less-than-astute investor
If you owned a business that had a net worth [shareholder’s equity]
of $100 million dollars and it made $5 million in profit, it would be
earning 5% on your equity [$5 / $100 = .05, or 5%]. The higher
you can get the “return” on your equity, in this case 5%, the better.
The formula for Return on Equity is:
Net Profit
----------(divided by)----------
Average Shareholder Equity for Period
Martha Stewart Living Omnimedia, Inc.

Excerpt – 2001 Consolidated Balance Sheet
(in thousands except per share data) 2001 2000
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Total Shareholders’ Equity 222,192 196,116
Total liabilities and shareholders’ equity 311,621 287,414
Martha Stewart Living Omnimedia, Inc.

Excerpt – 2001 Consolidated Balance Sheet
(in thousands except per share data) 2001 2000
Total Shareholders’ Equity 222,192 196,116
Total liabilities and shareholders’ equity 311,621 287,414
Now that we have the income statement and balance sheet in front
of us, our only job is to plug a the numbers into our equation. The
earnings for 2001 were $21,906,000 [because the amounts are in
thousands, take the figure shown, in this case $21,906, and multiply
by 1,000. Almost all publicly traded companies short-hand their
financial statements in thousands or millions to save space]. The
average shareholder equity for the period is $209,154,000
[$222,192,000 + 196,116,000 divided by 2].
Let’s plug the numbers into the formula.
$21,906,000 earnings
-------------(divided by) -------------
$209,154,000 average shareholder equity for period
The answer is 0.1047, or 10.47%. This 10.47% is the return that

management is earning on shareholder equity. Is this good? For
most of the twentieth century, the S&P 500 [a measure of the
biggest and best public companies in America] averaged ROE's of 10
to 15%. In the 1990’s, the average return on equity was in excess
of 20%. Obviously, these twenty-plus percent figures probably won’t
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endure forever. In the past two years alone, small and large
corporations alike have issued repeated earnings revisions, warning
investors they will not meet analysts’ quarterly and / or annual
estimates.
Return on equity is particularly important because it can help you

cut through the garbage spieled out by most CEO’s in their annual
reports about, “achieving record earnings”. Warren Buffett pointed
out years ago that achieving higher earnings each year is an easy
task. Why? Each year, a successful company generates profits. If
management did nothing more than retain those earnings and stick
them a simple passbook savings account yielding 4% annually, they
would be able to report “record earnings” because of the interest
they earned. Were the shareholders better off? Not at all; they
would have enjoyed heftier returns had the earnings been paid out.
This makes obvious that investors cannot look at rising per-share
earnings each year as a sign of success. The return on equity figure
takes into account the retained earnings from previous years, and
tells investors how effectively their capital is being reinvested.
Thus, it serves as a far better gauge of management’s fiscal
adeptness than the annual earnings per share.
The return on equity calculation can be as detailed as you desire.

Most financial sites and resources calculate return on common
equity by taking the income available to the common stock holders
for the trailing [most recent] twelve months and dividing it by the
average shareholder equity for the most recent five quarters. Some
analysts will actually “annualize” the recent quarter by simply
taking the current income and multiplying it by four. The theory is
that this will equal the annual income of the business. In many
cases, this can lead to disastrous and grossly incorrect results. Take
a retail store such as Lord & Taylor or American Eagle, for example.
In some cases, fifty-percent or more of the store’s income and
revenue is generated in the fourth quarter during the traditional
Christmas shopping period. An investor should be exceedingly
37 ofCreate
cautious not to annualize the earnings for seasonal businesses.
Calculating Asset Turnover

The asset turnover ratio calculates the total sales [revenue] for
every dollar of assets a company owns. To calculate asset turnover,
take the total revenue and divide it by the average assets for the
period studied. [Note: you should know how to do this. In lesson 3
we took the average inventory and receivables for certain
equations. The process is the same; take the beginning assets and
average them with the ending assets. If XYZ had $1 in assets in
2000 and $10 in assets in 2001, the average asset value for the
period is $5 because $1+$10 divided by 2 = $5]. A quick exercise
would benefit your understanding.
Asset Turnover:
Total Revenue
---------(divided by) ---------
Average assets for period
Alcoa
2001 Income Statement Excerpt
Period Ending: Dec 31, 2001 Dec 31, 2000 Dec 31, 1999
$23,090,000,000 $16,447,000,000
Total Revenue $22,859,000,000
$17,342,000,000 $12,536,000,000
Cost Of Revenue $17,857,000,000
$5,748,000,000 $3,911,000,000
Gross Profit $5,002,000,000
Alcoa
2001 Balance Sheet Excerpt
2000
2001 1999
Long Term Assets
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$1,072,000,000 $673,000,000
Long Term Investments $1,428,000,000
$14,323,000,000 $9,133,000,000
Property, Plant and Equipment $11,982,000,000
$6,003,000,000 $1,328,000,000
Goodwill $9,133,000,000
$821,000,000 $117,000,000
Intangible Assets $674,000,000
N/A N/A
Accumulated Amortization N/A
N/A N/A
Other Assets N/A
$1,894,000,000 $1,015,000,000
Deferred Long Term Asset Charges $1,746,000,000
$31,691,000,000 $17,066,000,000
Total Assets $28,355,000,000
In 2001 and 2000, Alcoa [Aluminum Company of America] had

$28,355,000,000 and $31,691,000,000 in assets respectively,
meaning there were average assets of $30,023,000,000 [$28.355
billion + $31.691 billion divided by 2 = $30.023 billion]. In 2001,
the company generated revenue of $22,859,000,000. When applied
to the asset turn formula, we find that Alcoa had a turn rate of
.76138. That tells you that for every $1 in assets Alcoa owned
during 2001, it sold $.76 worth of goods and services.
$22,859,000,000 revenue
---------(divided by) ---------
$30,023,000,000 average assets for period
There are several general rules that should be kept in mind when
calculating asset turnover. First, asset turnover is meant to measure
a company’s efficiency in using its assets. The higher the number,
the better [although investors must be sure compare a business to
its industry. It is fallacy to compare completely unrelated
businesses.] The higher a company's asset turnover, the lower its
profit margin tends to be [and visa versa].
Return on Assets
Where asset turnover tells an investor the total sales for each $1 of
assets, return on assets [or ROA for short] tells an investor how
39 ofCreate
much profit a company generated for each $1 in assets. The return

on assets figure is also a sure-fire way to gauge the asset intensity
of a business. Companies such as telecommunication providers, car
manufacturers, and railroads are very asset-intensive, meaning they
require big, expensive machinery or equipment to generate a profit.
Advertising agencies and software companies, on the other hand,
are generally very asset-light (in the case of a software companies,
once a program has been developed, employees simply copy it to a
five-cent disk, throw an instruction manual in the box, and mail it
out to stores).
Return on assets measures a company’s earnings in relation to all of

the resources it had at its disposal [the shareholders’ capital plus
short and long-term borrowed funds]. Thus, it is the most stringent
and excessive test of return to shareholders. If a company has no
debt, it the return on assets and return on equity figures will be the
same.
There are two acceptable ways to calculate return on assets.
Option 1:
Net Profit Margin x Asset Turnover
Option 2:
Net income
-----------(divided by) -----------
Average Assets for the Period
The lower the profit per dollar of assets, the more asset-intensive a
business is. The higher the profit per dollar of assets, the less asset-
intensive a business is. All things being equal, the more asset-
intensive a business, the more money must be reinvested into it to
continue generating earnings. This is a bad thing. If a company has
a ROA of 20%, it means that the company earned $0.20 for each $1
in assets. As a general rule, anything below 5% is very asset-heavy
[manufacturing, railroads], anything above 20% is asset-light
[advertising firms, software companies].
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Johnson Controls
2001 Income Statement Excerpt
Period Ending: Sep 30, 2001 Sep 30, 2000 Sep 30, 1999
$16,139,400,000
Total Revenue $18,427,200,000 $17,154,600,000
Cost Of Revenue $478,300,000 $472,400,000 $419,600,000
($9,800,000) ($13,000,000)
Preferred Stock and Other Adjustments ($8,800,000)
Net Income Applicable to Common Shares $469,500,000 $462,600,000 $406,600,000
Johnson Controls
2001 Balance Sheet Excerpt
2000
2001 1999
Long Term Assets
Long Term Investments $300,500,000 $254,700,000 $254,700,000
Property, Plant and Equipment $2,379,800,000 $2,305,000,000 $1,996,000,000
Goodwill $2,247,300,000 $2,133,300,000 $2,096,900,000
Intangible Assets N/A N/A N/A
N/A N/A
Accumulated Amortization N/A
Other Assets $439,900,000 $457,800,000 $457,700,000
Deferred Long Term Asset Charges N/A N/A N/A
Total Assets $9,911,500,000 $9,428,000,000 $8,614,200,000
Total Stockholder Equity $2,985,400,000 $2,576,100,000 $2,270,000,000
Net Tangible Assets $738,100,000 $442,800,000 $173,100,000
The first option requires that we calculate net profit margin and
asset turnover. In most of your analyses, you will have already
41 ofCreate
calculated these figures by the time you get around to return on

assets. For illustrative purposes, we’ll go through the entire process
using Johnson Controls as our sample business.
Our first step is to calculate the net profit margin. We divide

$469,500,000 [the net income] by the total revenue of
$18,427,200,000. We come up with 0.025 (or 2.5%).
We now need to calculate asset turnover. We average the

$9,911,500,000 total assets from 2001 and $9,428,000,000 total
assets from 2000 together and come up with $9,669,750,000
average assets for the one-year period we are studying. Divide the
total revenue of $18,427,200,000 by the average assets of
$9,660,750,000. The answer, 1.90, is the total number of asset
turns. We now have both of the components of the equation to
calculate return on assets:
.025 [net profit margin] x 1.90[asset turn] = 0.0475, or 4.75%

return on assets
The second option for calculating ROA is much shorter. Simply take
the net income of $469,500,000 divided by the average assets for
the period of $9,660,750,000. You should come out with 0.04859, or
4.85%. [Note: You may wonder why the ROA is different depending
on which of the two equations you used. The first, longer option
came out to 4.75%, while the second was 4.85%. The difference is
due to the imprecision of our calculation; we truncated the decimal
places. For example, we came up with asset turns of 1.90 when in
reality, the asset turns were 1.905654231. If you opt to use the first
example, it is good practice to carry out the decimal as far as
possible.
Is a 4.75% ROA good for Johnson Controls? A little research on MSN

Money Central shows that the average ROA for Johnson’s industry is
1.5%. It appears Johnson’s management is doing a much better job
than the competitors. This should be welcome news to investors.
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Projecting Future Earnings

We will save most of the discussion on future earnings for our later
lesson focusing exclusively on valuing a business. As a caveat, let’s
cover some of the basic principles:
1. The greatest indicator of the future is the past. If a company has

grown at 4% for the past ten years, it is very unlikely it will start
growing 6-7% in the future [short of some major catalysts]. You
must remember this, and guard against optimism. Your financial
projections should be slightly pessimistic at worst, outright
depressing at best. Being masochistic in finance can be very
profitable. It’s always the Pollyanna’s that get creamed.
2. Companies involved in cyclical industries such as steel,

construction, and auto manufacturers are notorious for posting $5
EPS one year and -$2.50 the next. An investor must be careful not
to base projections off the current year alone. He / she would be
best served by averaging the earnings over the past tens years, and
basing coming up with a valuation based on that figure. For more
information, read Valuing Cyclical Stocks: Assigning Intrinsic Value
to Businesses with Unsteady Earnings.
Formulas, Calculations and Ratios for the Income Statement

You’ve learned how to analyze an income statement! In segment
two, we are going to look at the income statements for three
companies in the S&P 500. Below is a list of the equations we have
covered in this lesson. You should memorize them as soon as
possible.
Gross Margin: gross profit ÷ revenue

R&D to Sales: R&D expense ÷ revenue
Operating Margin: operating income ÷ revenue [also known as
operating profit margin]
Interest coverage ratio: EBIT ÷ interest expense
Net Profit Margin: net income [after taxes] ÷ revenue
Return on Equity (ROE): net profit ÷ average shareholder equity for
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the period
Asset Turnover: revenue ÷ average assets for period
Return on Assets: Net profit margin * asset turnover or net income
÷ total average assets for the period
1Working Capital per Dollar of Sales: Working Capital ÷ Total Sales
1Receivable Turnover: Net Credit Sales ÷ Average Net Receivables
for the Period
1Inventory Turnover: Cost of Goods Sold ÷ Average Inventory for
the Period
1
These calculations were discussed in Investing Lesson 3: Analyzing
a Balance Sheet. They require both the balance sheet and the
income statement to calculate.
Putting it all Together

At this point, you should have the ability to understand the most
common entries on the income statement, calculate and compare
gross, operating, and profit margins, examine depreciation policies
and put competitors in the same industry on a comparable basis,
calculate ROE, ROA, and asset turnover, have a respectable
understanding of how businesses account for minority-owned stakes
in other companies, explain the difference between basic and
diluted earnings-per-share, appreciate share repurchase programs
when stock prices are falling, despise share dilution, be able to
explain what “underwater” options are, and discuss why EBITDA is a
worthless metric. Congratulations! I hope you feel it was time well
spent. Although there is always more to learn, you are further ahead
than a majority of people who own stocks, mutual funds, or bonds.
In the future, it may help to think of the income statement as

following this general outline:
Revenue – Cost of Revenue = Gross Profit
Gross Profit – All Operating Expenses = Operating Profit
Operating Profit – Interest Expense, Income Taxes, and
Depreciation = Net Income from
Continuing Operations
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Net Income from Continuing Operations – Nonrecurring events

[extraordinary items, discontinued
operations, etc] = net income
Net income – preferred stock and other adjustments = net income
applicable to common shares
Abercrombie and Fitch - 2001 Annual Income Statement

Now that you have come this far, we are going to analyze three
income statements. First on our list is Abercrombie and Fitch, a
specialty clothing retailer that has made a name for itself by selling
the 'college experience'. As of February 2, 2002, the company
operated a total of 491 stores [309 Abercrombie & Fitch stores, 148
abercrombie stores [tailored to a younger audience], and 34
Hollister Co. stores.] Notice that I've included a copy of the balance
sheet so we can calculate return on equity, return on assets, etc.
All financials are taken from the company's 2001 annual report,
pages 19 and 20.
Abercrombie & Fitch

Consolidated Statements of Income
(Thousands except per share amounts)
2000
Fiscal year ended 2001 1999
$1,237,604
Net Sales $1,364,853 $1,030,858
728,229
Cost of Goods Sold, Occupancy and Buying Costs 806,816 580,475
509,375
Gross Income 558,034 450,383
255,723
General, Administrative and Store Operating 286,576 209,319
Expense
253,652
Operating Income 271,458 242,064
(7,801)
Interest Income, Net (5064) (7,270)
261,453
Income Before Income Taxes 276,522 249,334
103,320
Provision for Income Taxes 107,850 99,730
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$158,133
Net Income $168,672 $149,604
Net Income Per Share:
$1.58
Basic $1.70 $1.45
$1.55
Diluted $1.65 $1.39
The accompanying Notes are an integral part of these Consolidated

Financial Statements
Abercrombie & Fitch

Consolidated Balance Sheets
(Thousands)
February 3, 2001
February 2, 2002
Assets
Current Assets
Cash and Equivalents $167,664 $137,581
Marketable Securities 71,220 -
Receivables 20,456 15,829
Inventories 108,876 120,997
Store Supplies 21,524 17,817
Other 15,455 11,338
Total Current Assets 405,195 303,562
Property and Equipment, Net 365,112 278,785
Deferred Income Taxes - 6,849
Other Assets 239 381
Total Assets $770,546 $589,577
Liabilities and Shareholders' Equity

Current Liabilities
Accounts Payable $31,897 $33,942
Accrued Expenses 109,586 101,302
Income Taxes Payable 22,096 21,379
Total Current Liabilities 163,579 156,623
Deferred Income Taxes 1,165 -
Other Long-Term Liabilities 10,368 10,254
Shareholder's Equity
Common Stock - $.01 par value 1,033 1,033
Paid-In Capital 141,394 136,490
Retained Earnings 519,540 350,868
661,967 488,391
Less: Treasury Stock, at Average Cost (66,533) (65,691)
Total Shareholders' Equity 595,434 422,700
Total Liabilities and Shareholders' Equity 770,546 589,577

46 ofCreate
Gross Margin
The first thing we do is calculate the company's gross margin.
Taking the gross profit of $558,034 and dividing it by $1,364,853,
we come up with .40996, or almost 41%. Applying the same
calculation to previous years, we find that in 2002, company's gross
margin was 41.2%, compared with 43.7% in 1999. As a potential
owner of the business, you want to find out why the gross margin is
falling, and if the trend is expected to continue. If the industry is
hit hard by economic conditions, calculate the gross margins over
the past three years for Abercrombie's competitors [such as Pacific
Sunwear, Gap, or American Eagle] to see if they are experiencing
the same problem.
Operating Margin:
We calculate the operating margin as 19.9% during 2001, 20.5% in
2000, and 23.5% in 1999.
Interest Coverage Ratio:

You will notice that the interest income is recorded as net. If you
think back to the lesson, you should remember that this means the
total interest expense and interest income were added together to
offset one another and the resulting figure recorded. In
Abercrombie's case, the company recorded -5,064 in interest.
Using this information to calculate the interest coverage ratio, we

take the earnings before interest and taxes [EBIT], of $271,458, and
divide it by the total interest expense of $5,064. The answer is
53.60. What does this mean? The company can afford to make its
interest payments 53+ times. Obviously, it is going to have no
problem making its relatively miniscule payments.
Net Profit Margin:

In 2001, Abercrombie had a profit margin of 12.4%. In 2000, the
profit margin was 12.8%, while in 1999, it stood at 14.5%. Once
again, this doesn't mean much unless you compare it to the profit
margins of competitors. Even then, it may be inaccurate because of
47 ofCreate
pricing strategy [for instance, Neiman Marcus may have a slightly

higher profit margin than Wal-Mart, but that is because of the two
retailers have different pricing strategies and business models.]
Return on Equity - ROE

Here's where we get to the juice. To quickly calculate
Abercrombie's return on equity, take the average shareholders'
equity [$595,434+422,700 ÷ 2] of $509,067 and divide it into the
net profit of $168,672. The answer, .3313, or 33.13%, is the return
that management is earning on the retained profits. Obviously,
your pocketbook will be much faster enriched if you allow the
company to retain all of the profits instead of paying them out as
dividends [can you reinvest the earnings at 33%? Probably not!]
If both Abercrombie and a competitor were selling for ridiculously

cheap [say 3 times earnings], you would want to go with the
business that was generating the highest return on shareholder
equity. Considering the average corporation earns between 10 and
15% on its equity, Abercrombie's high ROE should make your mouth
water.
Asset Turnover
Taking Abercrombie's average assets of $680,061.5
[$770,546+$589,577 ÷ 2], and dividing it into the total revenue of
$1,364,853, we find the company has an asset turn of 2.0. There
are several general rules that should be kept in mind when
calculating asset turnover. First, asset turn is meant to measure a
company’s efficiency in using its assets. The higher the number, the
better [although investors must be sure compare a business to its
industry. It is fallacy to compare completely unrelated businesses.]
The higher a company's asset turnover, the lower its profit margin
tends to be [and visa versa].
Return on Assets
Multiplying the 12.4% net profit margin by the 2.0 asset turn, we
get .248, or 24.8% return on assets. Using the second formula, we
48 ofCreate
divide the net income of $168,672 by the $680,061.5 average

assets, which we discover is .248 or 24.8%.
Share dilution
As a conservative investor, you should base your valuation on the
diluted earnings per share. Unfortunately, if you remember back to
our discussion on share dilution, you haven't forgotten the
clandestine tactics Abercrombie took by not including all possible
stock option dilution in the diluted EPS figure:
From Abercrombie & Fitch’s 10K:
Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of

Class A Common Stock were outstanding at year-end 2001, 2000
and 1999, respectively, but were not included in the computation of
net income per diluted share because the options’ exercise prices
were greater than the average market price of the underlying
shares.
If you believe that Abercrombie is undervalued at the current

market price and therefore expect the stock to rise, some of these
underwater options may become exercisable, reducing the EPS even
further. You would be wise to make a provision for these in your
valuation [for instance, if you take the net income of $168,672,000
and divide it by the diluted EPS of $1.65, you can see that
management estimates the possibility of a total of 102,225,454+
shares outstanding. You may want to add the 5,630,000
underwater shares to this figure, making the fully diluted
outstanding shares stand at around 107,855,454. Now, taking the
net income of $168,672,000 and dividing it by the true fully diluted
figure, you would get diluted EPS of $1.56 instead of $1.65.]
Although there is a possibility of these shares not being exercised,

practiced conservatism can make a big difference to your
pocketbook over time.
Final Thoughts on the Company
49 ofCreate
A quick look at the income statement shows that sales, gross profit,
operating profit, and the basic and diluted EPS have increased
steadily for the past few years, even though the gross, operating,
and profit margins have fallen slightly. These factors, combined
with the high return on shareholders' equity should leave an
investor fully satisfied with the business. Management has clearly
created shareholder value by increasing the amount of equity on the
balance sheet, and reinvesting profits at a high rate of return. If the
company's shares were to ever trade low enough, an enterprising
investor should have no problem holding Abercrombie in their
portfolio if the current conditions persists.
Brown Safety
Brown Safety* [a fictional company], is the manufacturer of safety
products such as chemical goggles, fire extinguishers, safety ropes,
and scaffolding for construction jobs. In 2001, the company
reported record EPS of $2.79, up from just $0.03 the year before.
Brown Safety
Consolidated Statements of Income
(Thousands except per share amounts)
2000
Fiscal year ended 2001 1999
$10,000
Net Sales $5,000 $20,000
5,000
Cost of Goods Sold, Occupancy and Buying Costs 2,500 10,000
5,000
Gross Income 2,500 10,000
1,000
General, Administrative and Store Operating 1,000 1,000
Expense
4,000
Operating Income 1,500 9,000
0
Interest Income, Net 0 0
4,000
Income from Continuing Operations Before 1,500 9,000
Income Taxes
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Investment Income $350,000 0 0
Provision for Income Taxes 70,510 600 1,350
Net Income $279,490 3,400 7,650
Net Income Per Share:
Basic $2.79 $0.03 $0.08
Diluted $2.79 $0.03 $0.08

100,000 shares outstanding
Those of you who looked closely at Brown's income statement may

have caught on to my trick. Excellent job. If you didn't, let me
explain.
Deteriorating Core Operations

In 1999, Brown had a 38.25% profit margin. In 2000, Brown had a
34.0% profit margin. In 2002, Brown had a 25.5% profit margin.
Don't believe me? Look close at the income statement. You will
see that each year, the total profit and revenues have been cut in
half, while SG&A expenses remained at a steady $1,000 [which
caused the decreasing profit margin]. In the most recent year,
Brown only made $1,500 pre-tax from its continuing operations.
Assuming a 15% tax rate, the net profit would have worked out to
$1,275 had it not been for investment income.
In the most recent year, Brown realized $350,000 in investment

income. Without this one-time boost to earnings, the company
would have reported EPS of just over $0.01. To drive home what
these means, assume Brown is trading at $5 per share [any number
will do, this is solely for illustrative purposes]. A well-meaning but
less-than-astute investor may scan the stock tables one morning
and see that Brown is trading at a a p/e ratio of 1.8 [$5 per share ÷
51 ofCreate
$2.79 EPS]. He gets excited, throws up his hands and calls his
broker to buy as many shares as possible. At this rate, he'd be
earning 55.8% on his investment!
Unfortunately, in a year or so, the investor will have a very

unpleasant surprise. If the current decline in the core business
persists, the company will report earnings of $0.005 [that's half a
penny!] per share. This makes the p/e ratio 1,000! Instead of a
55.8% return on his investment in 2002, the shareholder will earn a
pathetic .001%. He is going to lose a major portion, if not all, of his
investment unless the business has a large portfolio of stocks and
bonds that it can distribute to shareholders or continue selling for
cash [as was the case of the Northern Pipe Line, an oil
transportation company managed by the Rockefellers. The stock
was trading at $65 per share when Benjamin Graham studied the
balance sheet and realized the company had bond holdings worth
$95 for each share. The value investor tried to convince
management to sell the portfolio off, but they refused. Shortly
thereafter, he waged a proxy war and secured a spot on the Board
of Directors. The company sold its bonds off and paid a dividend in
the amount of $70 per share.]
The Moral
Why the over-simplified example? There will come a day when you
are analyzing a business, and on the surface, it will seem that
earnings are increasing and management is doing a splendid job.
Upon closer examination, you may find that the core business is
actually losing money, and all of the reported profits come from
one-time events such as the sale of a business unit, real estate,
intellectual property, marketable securities, or any other number of
assets. Unless you are buying a company because you believe its
liquidation value is higher than its current market price, you could
be in for a rude awakening when management suddenly doesn't
have anything left to sell or the losses in the core business have
spiraled out of control.
52 ofCreate
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Investing Lesson 4 - Printable Version http://beginnersinvest.about.com/library/lessons/nlesson4.

Investing for Beginners

Investing Lesson 4: Analyzing an Income

The primary objective of the income statement is to report to

To an enterprising investor, the income statement reveals much

As we progress through this series of investing lessons, you must

begin working through it. In the end, I think you’ll be surprised by

Below is a sample income statement taken from Walt Disney’s 2001

Total Revenue or Total Sales

revenue or total sales. This figure is the amount of money a

The revenue figure is important because a business must bring in

Many companies break revenue or sales up into categories to clarify

In thousands except earnings per share

Fiscal year ended Sep 30, 2001 Oct 1, 2000

Retail $2,229,594 $1,823,607

Specialty 419,386 354,007

Total net revenues 2,648,980 2,177,614

Starbucks’ sales come primarily from two sources: retail and

“Retail” revenues refer to sales made at company-owned Starbucks

Cost of Revenue, Cost of Sales, Cost of Goods Sold (COGS)

Total Revenue - Cost of Goods Sold (COGS) = Gross Profit

The gross profit figure is important because it is used to calculate

Gross Profit Margin

To calculate gross margin, use this formula:

For illustration purposes, let’s calculate the gross margin of

Greenwich Golf Supply

In thousands except earnings per share

Fiscal year ended Sep 30, 2001 Oct 1, 2000

Total Revenue $405,209 $315,000

Cost of Sales $243,125 $189,000

Gross Profit $162,084 $126,000

Assume the average golf supply company has a gross margin of

We can take the numbers from Greenwich Golf Supply’s income

$162,084 gross profit

The gross margin tends to remain stable over time. Significant

Putting It Together Thus Far:

Total Revenue $50

Cost of Revenue $20

Gross Profit $30

Gross Margin: .6 (or 60%)

Research and Development

How much should a company spend on R&D? It depends. In highly

Selling General and Administrative Expenses (SG&A)

limited to a certain percentage of revenue. This can be

Goodwill and other Intangible Asset Amortization Charges

The complexities of goodwill were explained in detail in the Goodwill

Non-Recurring and Extraordinary Items or Events

accurately predict future earnings. If, for instance, you were

What is the difference between non-recurring and extraordinary

Non-recurring items are recorded under operating expenses, while

*The term material is not specific. It generally refers to anything

Accounting for Extraordinary and Non-Recurring Items or

If you are attempting to measure how profitable a business has

in the one-time events to paint a more accurate picture. For

Operating Income = gross profit – operating expenses

The operating income figure is tremendously important because it is

Operating Margin [or Operating Profit Margin]

To calculate the operating margin, divide operating income by the

Some income statements report interest income and interest

The amount of interest a company pays in relation to its revenue

and earnings is tremendously important. To gauge the relation of

Interest Coverage Ratio

Interest coverage is the equivalent of a person taking the combined