Where do you look as a potential stock investor if you want to find out what a company’s profit is? Check out the firm’s income statement. It reports, in detail, a simple accounting equation that you probably already know:
Sales – expenses = Net profit (or net earnings, or net income)
Look at the following figures found on the income statement:
Sales: Are they increasing? If not, why not? By what percentage are sales increasing? Preferably, they should be 10 percent higher than the year before. Sales are, after all, where the money comes from to pay for all the company’s activities (such as expenses) and create subsequent profits.
Expenses: Do you see any unusual items? Are total expenses reported higher than the prior year, and if so, by how much? If the total is significantly higher, why? A company with large, rising expenses will see profits suffer, which isn’t good for the stock price.
Research and development (R&D): How much is the company spending on R&D? Companies that rely on new product development (such as pharmaceuticals or biotech firms) should spend at least as much as they did the year before (preferably more) because new products mean future earnings and growth.
Earnings: This figure reflects the bottom line. Are total earnings higher than the year before? How about earnings from operations (leaving out expenses such as taxes and interest)? The earnings section is the heart and soul of the income statement and of the company itself. Out of all the numbers in the financial statements, earnings have the greatest single impact on the company’s stock price.
Total Sales (Or Revenue) Amount 1. Sales of products $11,000 2. Sales of services $3,000 3. TOTAL SALES (Item 1 + Item 2) $14,000 Expenses 4. Marketing and promotion $2,000 5. Payroll costs $9,000 6. Other costs $1,500 7. TOTAL EXPENSES (Item 4 + Item 5 + Item 6) $12,500 8. NET INCOME (Item 3 – Item 7) (In this case, it’s a net profit) $1,500
Looking at the income statement, an investor can try to answer the following questions:
What sales did the company make? Businesses sell products and services that generate revenue (known as sales or gross sales). Sales also are referred to as the top line.
What expenses did the company incur? In generating sales, companies pay expenses such as payroll, utilities, advertising, administration, and so on.
What is the net profit? Also called net earnings or net income, net profit is the bottom line. After paying for all expenses, what profit did the company make?
The information you glean should give you a strong idea about a firm’s current financial strength and whether it’s successfully increasing sales, holding down expenses, and ultimately maintaining profitability.