How to Tell if a Business is Healthy, Growing & a Good Investment

by | Mar 9, 2023

If you invest in stocks, you must know how to read an Income Statement. It reveals if a company is profitable, growing, and worth further research.

But Income Statements can be confusing to read.

So, here’s an easy-to-follow system, with everything you need to know. I’ve used a coffee shop example to simplify.

The Income Statement is also known as a Profit and Loss statement.

It shows a company’s revenue, expenses, and profit over a period of time. This could be over a quarter, 6 months, or a year.

The income statement starts with revenue at the top and we subtract costs as we go down, to end at the profit. Also known as income or earnings.

The Income Statement

Revenue:

This is the money that the coffee shop brings in from selling coffee.

Cost of Goods Sold (COGS):

This is the cost of ingredients and other supplies needed to make the product (coffee) that the coffee shop sells.

This might include water, coffee beans, and milk.

Gross Profit:

This is calculated by subtracting cost of good sold from revenue. It shows how much the coffee shop is making, before accounting for Operating Expenses.

This is one of my favorite metrics to review, year on year or when comparing alternative companies.

Operating Expenses (OPEX):

These are the costs of running the coffee shop on a day-to-day basis. Common categories of OPEX might include:

Rent and utilities Insurance and legals Marketing and advertising

Operating Income:

This is the profit that the coffee shop makes from its ongoing operations, after accounting for costs of goods sold and operating expenses.

It can also be called “EBIT” = Earnings Before Interest and Taxes

Interest Expense:

If the coffee shop has any debt, this is the amount of money it pays in interest on that debt. This number can also be positive if the shop generates more interest than it spends.

Pre-tax Income:

This is the coffee shop’s profit before taxes are taken into account.

Income Tax Expense:

The amount of money that the coffee shop has to pay in taxes.

Net Income:

Also called “Earnings’ or “Profits”.

This is the coffee shop’s final profit after all expenses have been accounted for.

We want this number to be positive.

A useful ratio to calculate, from the company’s net income is…

Earnings Per Share (EPS)

If the coffee shop was publicly traded, this is the profit that each share of stock is entitled to.

It’s calculated by dividing earnings by the number of outstanding shares.

For Example

If a company makes $5 million and has 1 million shares outstanding, each share is entitled to $5.

EPS is $5 million / 1 million = $5 per share

EPS is a good comparison metric when assessing alternative investments.

The Income Statement

It shows you how much money a company is making and what it’s spending.

Comparing Income Statements from different periods can help you understand if a company is growing or shrinking. We want companies that are showing consistent growth.

Example:

A coffee shop had:

In Q1:

  • Revenue = $100,000
  • COGS = $50,000
  • OPEX = $20,000
  • Interest expense = $0
  • Income tax = $5,000

That would give them a:

  • Gross profit = $50,000 (revenue – COGS)
  • Operating income = $30,000 (Gross profit – OPEX)
  • Pre-tax income = $30,000 (Operating income – Interest expense)
  • Net Income = $25,000 (Pre-tax income – Income tax)

$50,000 gross profit $30,000 operating income $25,000 net income

In Q2:

  • Revenue = $110,000
  • COGS = $50,000
  • OPEX = $22,000
  • Interest expense = $0
  • Income tax = $5,000

That would give them a:

  • Gross profit = $60,000 (revenue – COGS)
  • Operating income = $38,000 (Gross profit – OPEX)
  • Pre-tax income = $38,000 (Operating income – Interest expense)
  • Net Income = $33,000 (Pre-tax income – Income tax)

By comparing these two periods, you can determine if the business is growing and importantly, the rate of growth.

For example:

  • Revenue grew by 10%
  • Operating income grew by 20%
  • Pre-tax income grew by 27%
  • and Net income grew by 32%.

Understanding the language of business (accounting) is a fundamental skill for successful investing.

Learning how to read an Income Statement will allow you to quickly determine if a company is profitable, growing, and worth further research.

0 Comments

Submit a Comment

Your email address will not be published. Required fields are marked *

More Articles Like this

What is the Cash Flow Statement?

What is the Cash Flow Statement?

The cash flow statement stands as a vital tool for assessing the profitability and liquidity of a company. It provides valuable insights into the inflows and outflows of cash, offering a comprehensive view of a company's ability to generate and manage its cash...

Sir John Templeton: From Stock Picker to Philanthropist

Sir John Templeton: From Stock Picker to Philanthropist

Sir John Templeton, was called "arguably the greatest global stock picker of the century" by Money Magazine. With his astute investment strategies and an unwavering belief in the power of long-term growth, Templeton achieved phenomenal success throughout his career....

What is The Income Statement?: Exploring Financial Performance

What is The Income Statement?: Exploring Financial Performance

If you've ever wondered how to measure the profitability of a business, then you're in for a treat. Today, we'll delve into the world of financial statements and explore the income statement's numerical secrets using our trusty lemonade stand as an example. Get ready...

Not sure what stocks to invest in?

Download our Free Toolkit for the Value Investor

Steal the ideas of Buffett, Munger and Marks.

Want to know what stocks Buffett, Munger, Ackman and Marks are buying?

 

This free guide will give you the tools to:

 

See what stocks fund managers are buying

See what politicians have recently bought

Analyse a company's financials

Screen for potential investments

and value stocks

 

You have Successfully Subscribed!

Ebook cover 4 STEPS TO INVESTING IN UNDERVALUED STOCKS

Looking for a way to find undervalued stocks?

 

This free blueprint will take you through the steps of investing in undervalued stocks just like Warren Buffett 

 

You will learn how to:

 

Screen for 'Warren Buffett' type stocks.

Analyse a company's history.

Research a company.

Prepare yourself to value a company. 

 

 

You have Successfully Subscribed!