Analyzing an Income Statement
Income Statement Analysis
The amount of net income or gross margin is important. However, it’s important to be able to evaluate the performance of a business or investment relative to another. There are a variety of ratios that allow comparison of income statements. A few examples include the percentage gross margin, the percentage profit margin, return on assets, and return on equity.
Ratios:
Percentage Profit Margin = Net Income / Sales Revenue
Return on Assets = Net Income / Total Assets
Return on Equity = Net Income / Equity
Percentage Gross Margin = Gross Income / Sales Revenue
Limitations of the Income Statement
It’s important to remember that the Income Statement does NOT represent the cash flows of the firm. There are some expense deductions such as depreciation that are not actual cash expenses. A business or investment may also be using accrual accounting.
Accrual accounting means revenues are recognized when a sale occurs. Expenses are recognized when they are incurred. That doesn’t mean the sale or expense occurs at the point in time when they are paid for in cash. The Statement of Cash Flows is used, instead of the Income Statement, to present the cash flows of a business or investment more accurately.
Other limitations of the income statement revolve around standard accounting practices. Transactions are likely recorded at historical cost. Income statements don’t reflect which costs are fixed or variable. This means a deeper look needs to be taken to analyze cost allocation and behavior over time.