Understanding the Income Statement

Income statements are one of three high profile accounting documents that summarize a companies earnings after expenses have been subtracted from revenue. The income statement is a statement of corporate profitability for a given time period whether it be quarterly or annually. Depending on whether a company is private or public, income statements are either made public via the securities and exchange commission in the case of public companies or private only made viewable by key corporate and ownership parties of interest.

The income statement is important because it demonstrates to corporate ownership how a company is performing, The income statement is also a necessary document for tax reporting requirements and is thus essential. These documents can also be audited by accounting organizations that do not have an obvious conflict of interest. Statements by auditors claiming the income statements comply with Generally Accepted Accounting Principles (GAAP) provide some credibility to the accuracy of the income statement.

Income statement items

The income statement is broken down into several lines on which positive or numerical values appear. These values may appear on a number of financial reports such as 10K annual reports, corporate prospectus', financial websites, or as downloaded or prepared on spreadsheets. The positive values are associated with income from revenue, and the negative values include cost of goods sold, expenses, depreciation, amortization and dividends paid. The retained earnings at the bottom of an income statement is often considered the most important number on the income statement, hence the phrase 'the bottom line'.  This number reflects the amount of revenue not spent by the company and may increase the net worth of the company and its shareholders. Some of the key values are listed below:

• Sales or Revenue: This is hopefully a positive number at the top of the statement
• Operating Expenses or Cost of Goods Sold (COG): This is always a negative number
• Net earnings after COG: This is the difference between Sales and COG
• Depreciation and Taxes: Also a negative number subtracted from Net earnings
• Net Earnings after Depreciation and Tax: Hopefully earnings are still positive
• Dividends paid out: This is a negative number that is subtracted from the last net earnings.
• Retained Earnings: After all is subtracted and tallied what is left is either a net gain or loss for the company.

Not every income statement is exactly the same as some companies don't pay dividends or have property that depreciates. For example, a small sole proprietorship or partnership may have no shareholders or dividend paying shares. They may also have had a net loss the prior year which can be carried forward to the following years gains reducing or eliminating taxes. Thus, there are unique tax related and business type factors that influence what expenses a business has to put on its income statement.

Income statements are financial statements that report a companies revenue, expenses and retained earnings for a period of time. These documents are snapshots of a company's financial performance and can also be used for calculating financial profitability metrics such as return on revenue (ROE), and Profit Margin on Sales. Income statements are also required by the Internal Revenue Service in order to report taxable earnings if any. 

These financial statements can be prepared by accountants or those familiar with a company's finances and financial record keeping. Income statements are considered important documents by shareholders, corporation owners and taxation authorities because of their ability to illustrate a company's financial performance. Income statements are either prepared every 3 months of a fiscal year or 1 time a year or both quarterly and annually.

Using Capital Turnover Ratio to Analyze a Company's Financial Statements

The capital turnover ratio, also defined as the working capital turnover ratio, measures how effective a company's use of debt is. The ratio is calculated by dividing sales revenue for a specific period of time by the difference between short-term assets and short-term liabilities for the same time period. (www.investopedia.com) The reason why liquid assets and liabilities are used is they are more reflective of capital cash flow for operations than long-term assets. The capital return ratio can be utilized in appraisal of a number of financial scenarios.

• Business valuation and profitability measurement
• Assessment of business performance
• Determination of variation in profitability over time
• Profitability in relation to market and/or operational returns
• Evaluation of acquisition risk

Using the capital turnover ratio to analyze a company's financial statement will assist in discovering return on debt. The higher the ratio, the greater the revenue return per dollar of debt is as measured by the ratio. Since time is a factor, the capital turnover ratio can change on a quarterly and annual basis.

For this reason, it may be more effective to measure the capital turnover ratio for different periods. If the differences in the ratio value are volatile, it indicates either fluctuating sales and/or variable debt. That is to say, if the ratio changes significantly over different time periods of measurement, sales and/or debt use may be unsteady and therefore the company may be a greater investment risk.

To illustrate how the capital turnover ratio is used, the following example can be used. Company X has a first quarter revenue of $500,000.00, its liquid assets for that same quarter are valued at $400,000.00 and liquid liabilities are $200,000.00. The difference between the assets and the liabilities are $200,000.00 making the ratio calculation $500,000.00/$200,000.00= 2.5. For the second fiscal quarter, sales decrease to $400,000.00, short-term assets increase to $450,000.00 and short-term liabilities increase to $250,000.00. The second quarter capital turnover ratio will consequently change to $450,000.00/$200.000=2.25.

The capital turnover ratio can be calculated over time to arrive at multiple indicators of return on capital including 1) an average capital turnover ratio 2) variable capital turnover ratios and 3) Correlated capital turnover ratio. The average capital turnover ratio will yield a ratio value that represents the capital return over a larger period of time whereas the variable capital turnover ratios can assist in determining seasonal, cyclical and environmental shifts in capital returns.

Furthermore, if the individual capital return ratios are correlated against a market index such as the Nasdaq, several other numerical relationships can be discovered. For example, quarterly percentage differences in the capital return ratio can be divided by quarterly percentage differences in the Nasdaq to determine if fluctuations in the ratio are statistically linked to variations in market returns over the same time period.

Additionally, the variable capital turnover ratio can be measured against internal performance benchmarks rather than against market returns as in the company to market beta relationship. That is to say, rather than relating the variable capital return ratios to a market index they can be related to other internal ratios such as profit margin on sales, return on equity (ROA) or return on assets (ROA).

To do this calculate the percentage change or average percentage change in the capital turnover ratio by dividing each periods capital turnover ratio by the previous periods ratio and then continuing on and averaging those percentage returns for an average variable capital return ratio percentage. Then, divide that value by the average percentage change of any one of several profitability ratios such as profit margin on sales, which is net income available to shareholders divided by sales. (Brigham and Houston p.107)

The result will be a numerical value reflecting the average variable capital return ratio as a function of profitability rather than market returns. In this case, the closer the value is to 1, the greater the connection between corporate operations and profitability to debt management.

In summary, the capital return ratio is a measure of profitability. The ratio can be expanded through multiple calculations over time to determine variation in profitability and average profitability. Additionally, the capital return ratio can be used in risk calculations by measuring it against market returns and operational performance by inserting the percentage change of the ratio in to a beta slope calculation where the numerator value is the capital turnover ratio percent change and the denominator is the operational percent change as measured by profit margin on sales.

A company that makes good use of debt leveraging is more likely to have a higher capital return ratio than a highly leveraged company with the same sales. For this reason, the capital return ratio us useful for business valuation purposes, assessment of business performance, and calculation of relationship(s) between profitability and market and/or operational performance.

Sources:
1. http://www.investopedia.com/terms/w/workingcapitalturnover.asp
2. http://www.investopedia.com/terms/a/alpha.asp
3. Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p.107.