Lecture 3

INCOME STATEMENT
ANALYSIS

Prof. dr. Anamaria CIOBANU

 Income Statement Analysis
Questions:
1. What is the structure of the Income
Statement? What are the main operating
revenues and costs?
2. What is the interest coverage ratio?
3. What is the level of the the profit margins and
earning per share?
4. What is the level of sales and quantity of
products to breakeven?
 Income Statement The Principle
(1/3)

The income statement provides us with

information about the companys revenues and
expenses over some previous time period
(usually quarterly, semiannually, and annually)
 Income Statement The Principle
(2/3)
The income statement presents in a summary
form the profitability of a firm over an annual
period

The income statement equation:

Revenue Expenses = Income
A positive difference indicates a profit.
A negative difference indicates a loss.
 Income Statement The Principle
(3/3)

Accrual Accounting
The revenues and expenses are reported based
on the principles of accrual accounting: there are
recognized as they are incurred rather than
when the cash is received or paid out

the net income will not reflect the cash

generated by the company
What is the connection between income
statement and the balance sheet?
 1. What is the structure of the Income
Statement? What are the main operating
revenues and costs?
 Income statement format
Subtotals
Gross profit (i.e., revenue less cost of sales)
Multistep format: Income statement shows gross profit
subtotal
Single-step format: Income statement excludes gross
profit subtotal
Operating profit (i.e., revenue less all operating expenses)
Profits before deducting taxes and interest expense and
before any other nonoperating items
Operating profit and EBIT (earnings before interest
and taxes) are not necessarily the same
Expense Grouping

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Income statement format: example 1
Colgate-Palmolive company

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Income statement format: example 2
LOreal Group

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Income statement format: example 3
Procter & Gamble

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 Common-size income statements
Panel A: Partial Income Statements for Companies A, B, and C
($) A B C

Sales $10,000,000 $10,000,000 $2,000,000

Cost of sales 3,000,000 7,500,000 600,000

Gross profit 7,000,000 2,500,000 1,400,000

Selling, general, and

administrative expenses 1,000,000 1,000,000 200,000

Research and development 2,000,000 400,000

Advertising 2,000,000 400,000

Operating profit 2,000,000 1,500,000 400,000

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 Common-size income statements
Panel B: Common-Size Income Statements for Companies A, B, and C
A B C

Sales 100% 100% 100%

Cost of sales 30 75 30
Gross profit 70 25 70

Selling, general, and

administrative expenses 10 10 10
Research and development 20 0 20
Advertising 20 0 20
Operating profit 20 15 20
Each line item is expressed as a percentage of the
companys sales.
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 Income statement format
ROMANIAN APPROACH
Operating revenues
- Operating expenses
= Operating income Operating Income
+ Financial Income
Financial revenues + Extraordinary Income
- Financial expenses = EBT
= Financial income - Corporate Income Tax
= Net Income
Extraordinary revenues
- Extraordinary expenses
= Extraordinary Income
 How is generated the net income of each
company? In what company should you invest?
2. What is the interest coverage ratio?
 How you interpret interest coverage
ratio?

https://www.outlookbusiness.com/the-big-story/lead-story/bad-debt-or-death-bed-2123
 3. What is the level of the profitability
margins and earning per share?
 Income Statement Ratios
Net profit margin = Net income/Operating Revenues (or Net Sales)
Net profit margin measures the amount of income that a company was able
to generate for each dollar of revenue.
Higher level of net profit margin indicates higher profitability (generally more
desirable).
Net profit margin can also be found directly on the common-size income
statements.
Also referred to as return on sales.

Profitability margins found directly on the common-size income statement.

Gross profit margin = Gross profit/Op. Revenues (or Net Sales)
Operating profit margin = Operating profit/Op. Revenues (or Net Sales)
EBITDA margin = EBITDA/Op. Revenues (or Net Sales)
EBIT margin = EBIT/Op. Revenues (or Net Sales)
Pretax profit margin = Pretax profit/Revenue
Net profit margin

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 Earnings per share
Earnings per share (EPS) is the net earnings available to
common stockholders for the period divided by the
weighted average number of common stock shares
outstanding
If firm has a complex capital structure, it will report
basic and diluted EPS.
EPS is extensively used by analysts in evaluating a firm.

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 EPS: Example 1
Basic EPS
Earnings available to common shareholders divided by weighted
average number of shares outstanding
Basic EPS = (Net income Preferred dividends)
Weighted average number of shares outstanding

Assume the following:

- Company had net income of $2,431 million for the year,
- 488.3 million weighted average number of common shares
outstanding
- No preferred stock, no convertible securities, no options
What was the companys basic EPS?

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 EPS: Example 1 Solution
Assume the following:
- Company had net income of $2,431 million for the year
- 488.3 million weighted average number of common shares
outstanding
- No preferred stock, no convertible securities, no options

What was the companys Basic EPS?

Basic EPS
= (Net income Preferred dividends)/Weighted average number of
shares outstanding
= ($2,431 $0)/488.3
= $4.98

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 EPS: Example 2
Weighted Average Number of Shares
Calculate
(1) the weighted average number of shares outstanding
(2) the companys basic EPS

Assume the following:

Company had net income of $2,500,000 for the year and paid $200,000
of preferred dividends.
1,000,000 Shares outstanding on 1 January 20XX
200,000 Shares issued on 1 April 20XX
(100,000) Shares repurchased on 1 October 20XX
1,100,000 Shares outstanding on 31 December 20XX

Copyright 2013 CFA Institute 25

 EPS: Example 2 Solution
Weighted Average Number of Shares
Weighted average number of shares outstanding
1,000,000 (3 months/12 months) Jan, Feb, Mar
+ 1,200,000 (6 months/12 months) AprilOct
+ 1,100,000 (3 months/12 months) Oct, Nov, Dec
= 1,125,000 Weighted average number of shares outstanding

Basic EPS
= (Net income Preferred dividends)/Weighted average number
of shares outstanding
= ($2,500,000 $200,000)/1,125,000
= $2.04

Copyright 2013 CFA Institute 26

 EPS: Example 3
If-converted method for Convertible
Preferred Stock
Assume a company has the following:
- net income of $1,750,000
- an average of 500,000 shares of common stock outstanding
- 20,000 shares of convertible preferred outstanding
- no other potentially dilutive securities
Each share of preferred pays a dividend of $10 per share, and each
is convertible into five shares of the companys common stock.
Calculate the companys basic and diluted EPS.

Diluted EPS
= Net income/(Weighted average number of shares outstanding
+ New shares issued at conversion)
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 EPS: Example 3
If-converted method for Convertible
Preferred Stock solution
Diluted EPS Using
Basic EPS If-Converted Method

Net income $1,750,000 $1,750,000

Preferred dividend 200,000 0

Numerator $1,550,000 $1,750,000

Weighted average number of shares

outstanding 500,000 500,000
If converted 0 100,000
Denominator 500,000 600,000

EPS $3.10 $2.92

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 4. What is the level of sales and
quantity of products to breakeven?
 Breakeven Analysis
Breakeven: Profit = 0
Sales = Variable Costs + Fixed Costs

Companys cost structure has an impact on the

level of sales and quantity of products to
breakeven.
Higher the fixed cost, higher the level of sales and
quantity of products to breakeven.
 Breakeven Analysis

Analysis of companys type of costs:

Fixed costs (F) :

Operating: depreciation & amortization, rents, general
administrative expenses, executives salaries
Financial: interest expenses, banking fees

Variable costs (VC) :

raw materials costs;
costs of direct labor;
 Breakeven Analysis

Sales @BE = Variable Costs + Fixed Costs

where:
Sales @BE = Sales at Breakeven
Q @BE = Quantity of products at Breakeven
VC = Variable costs
vc = variable costs per product
p = price per product
%VC = proportion of variable costs into sales

Sales = p x Q
Variable Costs = vc x Q = %VC x Sales

Sales @BE = %VC x Sales @BE + Fixed Costs

or
p x Q @BE = vc x Q @BE + Fixed Costs
 Breakeven Analysis
- example -

Sales (S)--(110 million units) $ 1,650

Variable cost of goods sold (VC) $ (1,353)
Gross profit (GP) $ 297
Fixed costs (F) $ (154)
Net operating income (NOI = EBIT) $ 143
 Breakeven Sales Computation
- example -

SOpBE = $154 = $154 = $154 = 855.6 million

1- ( )
$1,353
$1650
1 - 0.82 0.18

To breakeven the Company should have sales

worth of $855,600,000.
 Breakeven Quantity Computation
- example -

QOpBE $154.0 million $154.0 million

= = $2.70
$15.00 - $12.30

= 57 million units of products

To breakeven the Company should sell 57

million units of products.
 Breakeven Analysis
Fixed cost are having a leverage impact on the
volatility of earnings:
Operating leverage relates to the companys
operating cost structure (fixed operating costs).
Financial leverage relates to the companys capital
structure (fixed financial costs).

Fixed Fixed
Costs Costs
 Summary
The costs structure is connected to the characteristics of
the industry and Companys management decisions.
The most used profitability margin for comparison among
companies in the same industry is EBITDA margin.
Higher the debt leverage of the Company lower the
interest coverage ration and higher the Companys
default risk.
The diluted EPS should be estimated when the
Company has a complex capital structure.
The structure of the Companys cost has a major impact
on sales and quantity of products to breakeven.
 Exam problems (3/1)
Example:

2. At the end of the financial year you have the following

information about your companys activity: shareholders
equity = EUR 4.000 mil., long term loans =EUR 3.000 mil.,
sales= EUR 10.000 mil. EBITDA= EUR 2.000 mil.,
depreciation expenses = EUR 200 mil., interest rate on
companys long term loans is 6%, income tax 16%.
You have to estimate the following indicators:
- EBIT and Net income margins.
- Interest coverage ratio.
 Exam problems (3/2)
Example:

1. Yellow company reports for the end of the year accounts

receivable that are worth 500 mil USD, representing 35
days in sales (the collection period is 35 days). Also, the
company recorded a cost of goods sold (COGS) in the
amount of 1,000 mil USD, depreciation expenses of 600 mil
USD and interest expenses of 400 mil USD. The income tax
rate is 16%. Having this information, compute EBIT and net
profit margin. What is the level of the sales at breakeven
and what will be the impact on the breakeven if the interest
rate for the companys loans will increase?
 Exam problems (3/3)
Example:

2. The company X reported an increase of its sales at

breakeven from 300 mil. Euro to 340 mil. Euro. The variable
costs of the company represent 60% of its sales. Knowing
this information you have to estimate the change in the fixed
costs of the company that determined its sales at the
breakeven to increase from 300 mil. Euro to 340 mil. Euro.
 Home Work

Perform an income statement

analysis for Bartlett Company and
identify the issues the company has
in comparison with industry figures.

Indicator Industry average

(2009)
Gross margin 30%
Operating margin 11%
Net margin 6,2%
Earning per share 2.26
Home Work

Cooper Industries, Inc., began 2009 with retained earnings of $25.32 million. During the
year it paid four quarterly dividends of $0.35 per share to 2.75 million common
stockholders. Preferred stockholders, holding 500,000 shares, were paid two semiannual
dividends of $0.75 per share. The firm had a net profit after taxes of $5.15 million.
Prepare the statement of retained earnings for the year ended December 31, 2009.

Example of Statement of Retained Earnings Bartlett Company

Home Work