How to Analyze an Income Statement

1. 7/29/2012 Analysis of an income statement, Cannondale How to Analyze an Income Statement ACC 230, John Mainieri

2. 7/29/2012 Analysis of an income statement, Cannondale Order of Discussion Net Income and Net Profit Margin Net Sales Gross Profit and Gross Profit Margin Operating Profit and Operating Profit Margin Analyze the components of operating expenses Other items of interest: tax rate, extraordinary items etc.

3. 7/29/2012 Analysis of an income statement, Cannondale Net Income Net income is a measure of the overall profitability of the company. Net income is increasing by a whopping 33% per year. Net margin has increase each year: from 6.2% in 1995 to 8.3% in 1997. For every dollar of sales, Cannondale has earned 8.3 cents, in 1997.

4. 7/29/2012 Analysis of an income statement, Cannondale Net Profit Margin Net Profit Margin is the amount the company has earned, after all costs and expenses have been deducted, for each dollar of revcnue.

5. 7/29/2012 Analysis of an income statement, Cannondale Net Sales Growth in sales has been healthy at 20% in ’96 and 11% in ’97 but this does not account for all of the increase in net income.

6. 7/29/2012 Analysis of an income statement, Cannondale Gross Profit and Gross Profit Margin Gross profit is the amount the company has earned after deducting the cost of producing the product it has sold. Gross profit margin is the amount the company has earned, at the gross profit level, for each dollar of sales. High gross profit margins are important because they tell if the company has a niche in the market or a special product for which it can charge higher prices.

7. 7/29/2012 Analysis of an income statement, Cannondale Gross Profit and Gross Profit Margin High gross profit enables the company to invest in research and development, enter new markets etc. Increases in Gross Profit Margin also indicate either good cost control or the ability to increase prices while holding costs down.

8. 7/29/2012 Analysis of an income statement, Cannondale Gross Profit and Gross Profit Margin Gross profit margin has increased steadily from 35% in ’95 to 38% in ’97. This resulted in an increase in gross profit of 26% in ’96 and 15% in ’97. Except for 1995, Cannondale’s gross profit margins have been 2 to 5 percentage points higher than the industry average: for example, 37.6% compared to 35.6% for the industry in 1997 In 1997, Cannondale earned about 36 cents, at the gross profit level, for every dollar of sales.

9. 7/29/2012 Analysis of an income statement, Cannondale Gross Profit and Gross Profit Margin Although gross profit margins are not significantly higher than the industry, Cannondale has solid gross profits and margins, and is in good position to compete in the market place. Arguably, it has a niche in the market that will continue to allow it to charge higher prices for their product. Margins have been increasing from year to year indicating either higher selling prices or good cost control, or both.

10. 7/29/2012 Analysis of an income statement, Cannondale Operating Profit and Operating Profit Margin Operating profit (income) is a measure of how well the firm has managed the business, before taking into account non operating income and expense like interest, taxes and extraordinary items. The increase in operating profit for ’96 (32%) is close to the increase in net income for that year (34%) but the increase in ’97 is only 23% compared to the 33% increase in net income in that year.

11. 7/29/2012 Analysis of an income statement, Cannondale Operating Profit and Operating Profit Margin The company went for earning 11.1 cents per dollar of revenue in 1995 to 13.5 cents per dollar of revenue in 1997. Cannondale’s operating profit margin is 2 to 3 times the industry average in all three years.

12. 7/29/2012 Analysis of an income statement, Cannondale Analyze the components of operating expenses Selling, general and administrative expenses have remained constant as a percent of sales for 3 years. This is good but is neutral as far as the increases in net income are concerned Research and development expense has increased significantly from year to year but the amounts are small compared to other expenses. .

13. 7/29/2012 Analysis of an income statement, Cannondale Total Operating Expenses Total operating expenses are lower that the industry average for all three years: Cannondale’s operating expenses are about 24% of sales to roughly 30% for the industry. Cannondale has good control over its operating expenses.

14. 7/29/2012 Analysis of an income statement, Cannondale Decreases in interest expense are significant percentage wise (-43% and –29% for ’96 and ’97 respectively but don’t appear to be significant in dollars; a decrease of $3.5 million over two years.

15. 7/29/2012 Analysis of an income statement, Cannondale Other items of interest continued... Other income doesn’t seem to be important doesn’t seem to be important either. Although the % increases are very large, the dollar increase is about $.8 million.

16. 7/29/2012 Analysis of an income statement, Cannondale Other Items, taxes When we look at income before income taxes, however, we see that they had a significant impact on growth rates. Income before taxes increased 66% and 33% respectively.

17. 7/29/2012 Analysis of an income statement, Cannondale Other Items, taxes continued... Tax rates were about what is expected in ’96 and ’97 at 36% but the tax rate for ’95 was only 14% due to the federal tax credit in that year due to a change in the valuation of allowance of deferred tax assets.

18. 7/29/2012 Analysis of an income statement, Cannondale Other Items, extraordinary items The extraordinary item in 1995 did not have a significant effect on net income.

19. 7/29/2012 Analysis of an income statement, Cannondale Return on Assets (ROA) Return on Investment (ROI)Return on Equity (ROE) ROA and ROI are different names for the same ratios. See pages 208 and 209 of the Fraser text. You don’t have industry averages that are directly equivalent to the formulas used in Fraser. (See the next slide.)

20. 7/29/2012 Analysis of an income statement, Cannondale Industry Averages for ROA and ROE If you want an industry average, you can use: % Profit Before Taxes/Tangible Net Worth for ROE % Profit Before Taxes/Total Assets for ROA How ever you must use comparable ratios for the company you are analyzing.

21. 7/29/2012 Analysis of an income statement, Cannondale Writing your introductory paragraph You can’t write this until you’ve finished your detailed analysis. Your introduction should tell me what your are going to tell me about the story revealed by your analysis of the income statement. Don’t forget an “opener.”

22. 7/29/2012 Analysis of an income statement, Cannondale Writing your summary You may or may not use all the analysis you prepared previously. The art of writing a good summary is to pick out those items that are most important to understanding the story the financial statements are trying to tell. Be sure your summary ties back to what you said in your introduction.