Tuesday, September 24, 2013

Understanding financial statements (Part 1) - The income statement

To be an investor, you have to know how to read financial statements. I would say that this is a skill that every investor must know. In fact, Warren Buffet said that the greatest skill a young person can learn during his or her school days is the skill of accounting.


In an annual report, you will basically find 3 financial statements.

1) The Income Statement
2) The Balance Sheet
3) The Cash Flow Statement

I will go through all 3 statements in detail as simple as I can. For this post, we shall use the company Singtel's financial statement as an example. It is the largest company listed on SGX in terms of market capitalization. It is also one of the blue chip stocks and is one of the 30 components stock that make up the Straits Times Index (STI).

Let's start with the income statement.

The Income Statement

I personally use investing.businessweek.com to read up on a company's financial report. You can access Singtel's income statement here. Alternatively, you can get the full annual report from either SGX or Singtel's own investor's relation website.


Revenue
The income statement shows how much a company is making or losing. The first thing we see on the income statement is revenue. It is the sales the company has made for that quarter or year. This is the money it earned through selling a service or product. For Singtel, it can be the selling of mobile phone service which we pay a monthly subscription. The money collected is recorded as revenue. For Singtel, its 2012 revenue was $18.18 Billion

Cost of goods sold
Next, we see the cost of goods sold. This is the cost that is directly involved in creating the revenue. It can be labor costs, raw material costs, or the initial cost price of the goods. This is deducted from the revenue.

Gross Profit
After deducting cost of goods sold from revenue, we get gross profit. Gross profit is revenue minus cost of goods sold. For Singtel, its 2012 gross profit was $5.5 Billion. This is after deducting cost of goods sold of 12.7 Billion.

Selling General & Admin Expenses, Total
Next we see Selling General & Admin Expenses. This is also known as operating expenses and includes expenses such as marketing costs, administrative salaries and research and development costs.

Depreciation & Amortization, Total
The next is Depreciation & Amortization. This cost is the depreciation on assets that the company purchases. Assets like machineries and motor vehicles will drop in value over time. The depreciation reflects the cost of the depreciation.

Operating Income
Another important one we should know is operating income. This is revenue minus cost of goods sold and also all operating expenses. It is the profit the company made from its actual operations. For Singtel, it is the earnings from its main business in the mobile, internet and IPTV services.

Interest Expense/Income
You'll see the next 2 rows being interest expense then interest income. This records the interest the company paid on bonds it issued or the interest collected from bonds it owns.

EBT, Including Unusual Items
EBT means earnings before taxes. A more accurate term you can look at is EBITA. This is earnings before interest, taxes and amortization. You will realise that before the EBT, there is a big chunk of expenses called other non-operating expenses. Accountants may remove this expense and not include it in the calculation towards earnings.

Net Income
This is the company's profit after all expenses have been deducted. It is the income that most companies will report on when they release thier earnings result. However, do note that the figure may be distorted as it includes one time charges or investment income. It does not really reflect on the true operating profit of the company. Investors sometimes look at operating income as it reflects the income earned from its actual operations in the business.

Summary
We have just gone through the various items included in the income statement. In summary, the income statement reflects the income and expenses of the company. For an investor, we do not just analyze a company's earnings power using the income statement only. You'll come to realise that the cash flow statement is a more accurate measure of a company's financial health. Income can be distorted more easily while cash flow is harder to fake. It is the actual cash that flows into the company business.

The next 2 financial statements, namely the balance sheet and the cash flow statement, will be discussed in the next part.

Read the other 2 financial statements below:
2) The Balance Sheet
3) The Cash Flow Statement

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