Financial Statement Breakdown: The Basics of the Income Statement

Financial statements can be confusing, especially if you don’t know what to look for. If you’re intimidated by financial statements, don’t worry. I used to be too. That’s why we’re doing a three part series to go over the lines on the income statement, balance sheet, and cash flow statements. In this post, we’re going to go over how you can extract information from the income statement. Last week, we briefly touched on some of the things to look for when using fundamental analysis. This week we will expand on those ideas.

EPS and Net Income 

The first thing you can look at on the income statement is whether you are viewing quarterly or annual data. Personally, I prefer to look at the annual data, as it gives me a better idea of what a company is capable of year over year. This is generally more consistent than quarter over quarter.

The most important line to look at on the income statement is the Net Income. Net income is important because it shows you how much money the company is actually making. Net income is calculated by taking the total amount of money made by a company and subtracting its expenses. Therefore, net income is the total profit generated by a company.

Net income then translates into EPS, or earnings per share. EPS is a company’s profit divided by the amount of common outstanding shares. EPS is important, as it shows you how much profit is being generated by the company for each share that is outstanding. On top of that, EPS is used in a lot of valuations. In addition, it is useful to look at EPS for a company year over year to determine whether or not the company is growing or shrinking. Look for companies that grow their EPS!

P/E and P/S Ratios

Once you have the net income and EPS, you can calculate the Price to Earnings ratio, or P/E ratio. The P/E ratio allows you to see how the price of a company is relative to its earnings. This is useful when you want to take a quick look at whether a company is overvalued or not.

Generally, speaking you want to look at companies that have below 15 as their P/E if you are a value investor. Companies with a ton of hype tend to have ridiculously high P/Es, correlating with them being overvalued. Take Netflix, for instance. NFLX at the time of this writing has a P/E of 303.9. High P/Es take into account the expected growth of a company. However, I have a hard time believing that NFLX will be able to catch up to its P/E of 303.9. Therefore, I would consider NFLX overvalued at an eye-level.

Another ratio you can get from the income statement is the P/S, or Price to Sales ratio. The P/S ratio is a good number to look at with the P/E ratio. I always look at the P/S after the P/E, as it is much harder to manipulate the P/S with accounting tactics.

The P/S ratio is calculated by taking a company’s market cap and dividing it by the revenue. Revenue is the money a company makes before expenses, so it is more difficult to write off through accounting. This is useful because it gives you an idea of the value you are receiving for a company. If the P/S is close to or below 1, then you are getting a great value!

Conclusion

There are many things that you can look at on an income statement to tell you about a company. Primarily, we want to look for companies that are making a lot of net income, as it means they are very profitable. In addition, it is great if this net income is growing year over year.

Once you take a look at the net income, possibly splitting it into EPS, you can start looking at value ratios. P/E and P/S are great metrics that can give you an idea whether the price of a stock is good value for what you are getting. Make sure to use both of these metrics, don’t just rely on one!

If you like the metrics discussed in this post, consider joining our Insider’s List. By signing up with an email, you’ll receive a free value cheat sheet with all of the metrics I use to determine what stocks are worthwhile!

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