Coming now to section 7 which is Analysis of the Income
Statement. Broadly speaking, there two ways to analyze
the income statement and both these methods are actually
related. One is to look at a common size income statement,
the other is to look at ratios. With a common size income
statement, every item on the income statement is
taken as a percentage of sales or net sales. Here,
we are looking at every item as a percentage of net
sales. In 2011, the company had net sales of 1 million,
so 1 million as a percentage of 1 million is 100%. Cost
of goods sold is 500,000, this is 50% of the net sales
and so on. The advantage of doing a common size income
statement is that you can look at every item and see that
item as a percentage of sales. Then if you do a time
series analysis of the company, look at how numbers
are changing overtime. Notice that cost of goods
sold went from 50% of net sales to 58.5%. So, this means
that cost of goods sold is actually increasing quite
a lot, perhaps suppliers increased their cost. Looking
at the percentages is much more meaningful than
looking at the absolute increase in cost of goods
sold, because it is quite possible that the net sales
goes up by so much that cost of goods sold goes up in
absolute terms, but in percentage terms it doesn't
go up that much or in percentage terms, it might also go
down. But looking at the common size statement gives
you a clearer picture of what's happening relative
to revenue. This is a time series analysis. If you
look at the curriculum, the curriculum also shows
a cross-sectional analysis where you can compare
numbers for different companies over the same time period.
But again, the main point to remember is that with
a common size income statement all numbers are expressed
as a percentage of sales. Some of the most important
ratios that you can extract from the income statement
are gross profit margin, operating profit margin,
and net profit margin. Gross profit margin is equal
to the gross profit divided by sales, and notice that, that number
is also given in the common size income statement.
Gross profit divided by sales is 50% over here. Gross profit
divided by sales for 2012 is 41.5. So, it looks like
the gross profit is going down which makes sense
given that the cost of goods sold is going up. The operating
profit margin is essentially the operating profit
or EBIT divided by sales. In this particular case, the operating
profit margin is 17%, in 2011, and down to 7.6% in 2012,
so that also is a negative trend. Net profit margin
is net income divided by net sales and notice that, that
number is going down also. Comprehensive income.
Here is a topic that we'll cover in this reading on the
income statement, and then when you see this item
in the next reading on the balance sheet it will make
more sense. Comprehensive income is equal to net
income plus other comprehensive income, Net income
is what you show on the income statement, it's
the revenue minus expenses which are reported on
the income statement. And then there are other revenue
and expense items which are excluded from the net
income calculation, that impact is captured in something
called other comprehensive income which is a part
of equity, but at this stage you simply need to memorize
a few core points, and over the next few slides these
points would make more sense, and when you do the reading
on balance sheet it will make even more sense. There are four
types of items that are treated as other comprehensive
income: Unrealized gain/losses from a certain category of investment security,
called AFS, is treated as other comprehensive income.
This means that if the value of an AFS security
goes up that is a gain, but this gain is not shown in
the income statement it is shown in the equity segment
of the balance sheet as other comprehensive income.
We will see this in detail in the next reading on the
balance sheet. Then these other items, you just need to memorize
for now and you will learn about them when you do level
2 of the CFA program. Foreign currency translation
adjustment, unrealized gain/losses on derivative
contracts used for hedging, and certain costs of
a company's defined benefit post-retirement plan.
So these are items which impact OCI and not the net income.
I'll give you a simplistic illustration of how other
comprehensive income works. Let's say that at the
start of the year we have this balance sheet, a company
has 100 invested in AFS security and 1,000 invested in
property, plant and equipment. Those are the only
assets, there are no liabilities, equity therefore
is 1,100 and notice our basic equation balances--assets
equal liabilities plus equity, liabilities are
zero. Over the year, here is the very simple income
statement; revenue 300, expenses 100, so net income
is 200. We assume that the entire net income is retained. In
other words, no dividends are paid and the AFS security
which started out at a 100 now goes up to a 120.
So, what does the balance sheet look like
at the end of the year? Remember, I just mentioned
that the increase in value of a AFS security is part
of other comprehensive income. This increase of
20 is shown as other comprehensive income. So, a comprehensive
income for the year is equal to the net income, which
is 200, that's coming from there, plus other comprehensive
income which is 20. So, the comprehensive income
is equal to 220. Let's look at the balance sheet.
The cash is 200--this is coming from the net income,
so that's right there. The AFS security has gone up 120,
so that's shown over here. Assume that the property,
plant and equipment is still at a 100,000,
and equity has gone up to 1,320. Notice that the increase
in equity is 220, so the total comprehensive income shows
us how we go from the original equity number of 110,000
to the new equity number of 1,320.
The net income or even the retained net income alone
does not explain the difference between these two
numbers, that differences explained using comprehensive
income, which is a combination of net income and
other comprehensive income. So, to consolidate
this concept, let's do the example shown here. At
the start of the year, the equity for this company
is 2,200,000. We are told that the net income is 1.6
million and the amount paid as a dividend is 800,000.
So the retained earnings for the year equal 800,000.
The ending shareholder equity is 3.2 million. Now,
if you recall, the item that explains the difference
between 2.2 million, the starting equity, and the ending
equity, 3.2 million, is the comprehensive income,
and comprehensive income is made up of net income
or actually the retained earnings and other comprehensive
income. The retained earnings equal 800,000. So, we
have 2.2 million plus 800,000 plus, this OCI is going to give
us 3.2 million. So, what is OCI? OCI has to be 200,000.
So that is the answer to this question. OCI is 200,000.
That brings us to the end of this long reading, we will
cover the most important points briefly. The first
thing we talked about was Revenue Recognition.
This is extremely important and I will summarize
the two most important revenue recognition items.
The first is, that the product or service has to be
delivered, and the second is that we need to be reasonably
sure of collecting cash. We then talked about revenue
recognition for long-term contracts and for installment
sales. Expense Recognition, the key point here is
the matching principle. Non-Recurring Items and
Non-Operating Items. As an analyst, we need to understand
what items will recur in the future, what items will
not recur. This helps us make projections. We need
to understand how much money is being made from the
core operation of a firm versus income that is coming
from non-core activities. We need to understand
the basic and diluted EPS calculation. So make sure
you understand all the examples that we talked about.
Common Size Income Statement and Ratio analysis. These are
tools that we used to analyze the income statement.
We talked about them briefly here, later there will
be a reading on the analysis of financial statements
which will cover these items in more detail. And
finally, we talked about comprehensive income which
is equal to the net income plus OCI. As always, I will
encourage you to read the summary in the curriculum.
Review the learning objectives, go over the examples
in the curriculum, do the practice problems and these
are very good but not enough. So, also try to do as many
practice questions as you can from other sources.
That is it.