Simplifying the Income Statement
It’s a bit dangerous to propose that the income statement of a business can be simplified. If you were to make a business decision (stock purchase, buy a business, etc.) just from this idea, you could find yourself in a heap of trouble financially.
However, simplifying the income statement is a good place to start your analysis. Without going into too much detail yet, try the following exercise:
- Pick the company you have been considering as an investment and find its ticker symbol. You'll need this for your research. It can be something you already own, too.
- Download as many years of an income statement as you can. If you just use the net income, that is the simplification this article is focusing on. You are free to choose other data points as well.
- Place each year of the data in a separate column in a spreadsheet.
- Find the year-over-year percentage change of the net income (how to is shown below).
The following are common sources you can use to obtain financial data:
The above are free sources. You can get several years of data from the SEC’s website, but it is a manual process. Yahoo and Morningstar both supply three years of data. For this simplified method, you want several years. StockRow.com offers 10 years. This is the source used in this article.
To determine growth rates, the formula is:
(Current Period Net Income – Previous Period Net Income) / Previous Period Net Income.
So, if the current year has a net income of 100 the previous year is 80, plug these numbers into the formula:
(100 – 80) / 80 = .25 or 25%
The 100 represents an increase from the previous year of 25%.
An alternative way to perform this calculation is to divide the current period by the previous period and subtract one from the total. Therefore:
(100 / 80) - 1 = 25%
Make this calculation for every year available. If you have 10 years of data you will have 9 growth rates.
What to Look For
Overall, you want to look for companies that have steady and consistent growth. If a company is able to grow its income for 10 years straight, this can be a good first indication that you have come across a solid company that is well run by its management.
In a perfect world, you would find hundreds of companies with steady growth patterns. However, this is the same world where you can visit a garden full of unicorns. It’s not going to happen.
The point is, because you won’t find many companies that have perfect records of increased earnings, you either need to keep looking, or you need to have some flexibility with the process. You could choose companies that only have positive net income even if every year isn’t an increase. Or, if you can find information about why the company suffered during a few of the years and the explanation is reasonable, then you can to add it to your watch list.
Understand that this type of simplified analysis is intended to give you a quick overview of companies to consider. It’s never advisable to invest based on this item alone. The company could have mountains of debt that is not serviceable or some other problem working against the company. It’s also possible for a company to have positive net income but negative cash flow for several periods. The main reason for this disconnect is from the use of an accounting principle known as accrual accounting. This type of accounting is believed to accurately portray the business operations but can leave a company with a cash flow crunch. The concept recognizes revenues when the product or service is delivered, not when the cash is received. The expenses are matched to the revenues even if these expenses have yet to be paid.
The great aspect of this type of simplified analysis is you can weed out bad companies quickly. . A company that has existed for ten years and hasn’t been able to grow its net income is going to eventually run in trouble sooner or later (usually sooner).
What Growth Rate Should You Require?
The actual growth rate is not as important as the trend of growth. However, low growth rates of one or two percent is reason to proceed with caution. Solid companies should grow by at least six or seven percent. You could require even higher rates. The choice is yours. You will need to draw your line in the sand. But, you should be realistic and learn what growth rates are average for the industry.
Different industries will experience different growth rates. Many innovative companies can grow at 15 percent or more. Some high fliers grow in the 25 percent range. Be aware that this can sometimes indicate hidden problems. The old adage if something is too good to be true, it probably is. A company with a huge economic advantage could justify a high growth rate. But,you should always investigate what is generating the growth and feel comfortable with the reasons you learn.
This exercise gives you a first pass at companies that offer potential for your portfolio. However, you need to research these companies further. This analysis is rudimentary and will only show you one aspect of a company's health There are several other indicators that you should use to further evaluate companies. But, this is a good start and can weed out several companies that don't meet your criteria.