One method for judging a corporation is to compare transparency, a company's willingness to disclose everything. Does your company explain off-balance sheet liabilities and provide adjusted ratios for you?
For example, if a corporation has entered into a long-term lease obligation, both current and long-term liabilities are actually much greater than they appear on the balance sheet. You need to go through the notes to the financial statement to discover these very real, but undisclosed liabilities. The footnotes invariably exist; but their significance may not be obvious to the nonaccountant or to the novice investor.
The lack of disclosure may easily distort the true picture, just as increases in long-term debt may distort a seemingly positive trend in the current ratio. The solution is to develop an ability to understand footnotes, and to adjust your trend analysis so that your trends and ratios are complete and realistic. Working through an investment club makes this task easier; using the services of a financial planner who understands the fundamentals is also worth considering.
Even if you perform your own tests, it is not too difficult to develop a series of balance sheet ratios that reveal useful information. Even if liabilities are not included on the financial statement, you can use the information you do have in combination with income statement ratios to gain a fair idea of the company's fiscal health. In the best-managed companies, footnotes are clearly expressed and important ratios may even be calculated for you based on inclusion of items not on the balance sheet. The common problem is an inadequate and antiquated set of accounting rules and the lack of reform, combined with a widespread attitude among corporate executives and auditors that investors don't care about fundamental ratios. However, in reality investors not only care about getting more accurate information; many are frustrated and distrustful of the audited statement and of the complexities of financial reporting. There are solutions, but most investors need to do their own work to find out what is taking place beyond the disclosures on the balance sheet.
The next chapter moves analysis beyond the balance sheet, to the income statement. The ratios and trends you follow on this statement focus on profits and the potential for growth in future earnings.
Income Statement Ratios
Tracking the Profits
The easiest job I have ever tackled in this world is that of making money. It is, in fact, almost as easy as losing it. Almost, but not quite.
—H. L. Mencken, Baltimore Evening Sun, 1922
The income statement is a summary of revenues, direct costs, expenses, and profits for a specified period of time such as a month, quarter, or fiscal year. The ending date of this period corresponds to the fixed date of the balance sheet. An income statement may cover the period of January 1 through December 31; and the balance sheet published at the same time reports balances of assets, liabilities, and net worth accounts on December 31.
The most popular types of fundamental analysis involve income statement ratios because most analysts—both fundamental and technical— recognize the essential role of profits in the valuation of stocks. Even those who only track a stock's price and who have no interest in the financial statements acknowledge that earnings announcements immediately affect stock prices.
This chapter describes and provides examples of such ratios and shows how they reveal specific trends concerning future growth, the value of stock as a potential investment, and the position of a corporation within its own industry.
income statement ratios tests of financial trends and status based on comparisons between accounts found on the income statement, or outcomes found on income statements and tracked over a period of time.
margin a gap, remainder, or space between groupings of accounts on the income statement, usually expressed as a percentage; at times interchangeable with "return" and "yield." Typically, analysts study gross margin, operating margin, and pretax margin.
return the profit remaining when costs and expenses are deducted from revenues; the percentage of profits on original amount invested; or the percentage of profits to equity in a corporation— various types of calculations, usually expressed as a percentage, in analysis of the income statement.
yield the return, profit, and percentage gained. The term is used on the income statement to compare profits to revenues, amount invested, or equity; or to compare dividends to the current stock price.
Some of the language used in income statement analysis is confusing. You will hear discussions and descriptions of margin, return, and yield. While these terms have some distinctions, they are often used interchangeably in regard to the income statement. A margin is a remainder, gap, or space between various sections of the statement. For example, the gross margin is usually expressed as a percentage, based on the gross profit (revenues minus direct costs) divided by revenues.
A return, like a margin, is expressed as a percentage and the word is often used to mean the same thing as margin. Some ratios, however, such as net return, are popularly used to describe profits to revenues. Return also has broader applications beyond the income statement. For example, return on equity is another ratio that compares profits to dollar amounts beyond the income statement.
Yield is distinguished from margin and return because it often is an investment-based calculation rather than one limited to the income statement. "Net yield" is often used as an alternate description of what is more commonly known as net return. Yet it is more common to compare a financial value to stock price. For example, the dividend payment during a complete year, divided by the current stock's market value, is called current yield.
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