"Really Useful Financial Ratios
Can Be Calculated From 
'The Income Statement'
In An Effort To Discover Cheap Stocks"

"Use These Numbers (and Others) To Find 'The Holy Grail' of Investing - Companies That Are Valued Cheaply"

Introduction

'The Income Statement' is one of three important financial statements that inform, amongst other criteria, how much money a company has earned over a set period of time.

Company accountants generally produce these statements every three months (i.e. each quarter) and at the fiscal year end.

From 'The Income Statement' investors can discover ratios such as:

• Margins
  
• Dividend cover
  
• Interest cover
  
• Sales, earnings, and equity per share
• Staff costs as a percentage of sales
• Directors' remunerationas a percentage of net income
• Sales and profit per employee

and many more.

"What is The Income Statement?"

The 'Holy Grail' of investing is trying to find a company that has a Durable Competitive Advantage.  Not our terminology but Warren Buffett's revelation.

'The Income Statement' is one of three Financial Statements that investors must understand. The other two being 'The Balance Sheet' and 'The Cash Flow Statement'.

Financial Ratios are what us lay investors can understand and many ratios can be extracted from the 'Income Statement'. See the section below for more details.

The Income Statement (also called the 'Profit and Loss Statement') has three basic components:

1. The company revenue
2. Company expenses
3. The company profit

Warren Buffett, our hero, pays particular attention to a company's earnings.  He identifies companies as belonging to two distinct groups:

• Those with a 'Durable Competitive Advantage'
• Those that continually struggle year-in, year-out, in competitive markets

Which type of company do you think he favoured?

"How is The Income Statement Made Up?"

Please understand, although it may be patently obvious, that we are not financials buffs.  Or financial anythings.  All we are trying to do is make sense of information at hand in order to make informed decisions.

In that quest, we just want to model what Warren Buffett does.  But without any of the number crunching.  We'll leave that to the experts.

So, being simplistic we want to get to the 'Financial Ratios' derived from each 'Financial Statement' but with a moderate understanding of what each one means.

In that respect we consider it sufficient to know how each Financial Statement is made up and, in turn, that should make any 'Financial Ratio', easier to understand.

As just described above, the 'Income Statement' has 3 components.  Revenue, expenses and profit. 

Let's briefly summarise each one:

1.  Revenue.  The first entry on any Income Statement is 'Gross Revenue'.  Next comes the 'Cost of Goods Sold'. The difference between the two is the 'Gross Profit'.

2.  Expenses.  This is typically divided into: 

                        a) Selling, general, and administration
                        b) Research and development
                        c) Depreciation
                        d) Interest
                        e) Gain (or loss) on sales of assets
                         f) Any other expense

3.  Profit.  Any income before tax.  Income tax paid.  Net earnings. 

A typical 'Income Statement' may look something like:

                                                                 £ Millions

Revenue                                                   20,000
Cost of Goods Sold                                    5,000
Gross Profit                                              15,000

Operating Expenses
Selling, General and Administration           2,600
Research and Development                       2,500
Depreciation                                                   800
Operating Profit                                           9,100

Interest Expense                                            300
Gain (or loss) on Sale of Assets                  1,300
Other                                                               450
Income Before Tax                                       7,050
Income Taxes Paid                                       1,162
Net Earnings                                                 5,888

From all this information, the number crunchers can do their bit and reveal the ratios that us ordinary folk can comprehend.  See the section underneath.

"What Financial Ratios Are Derived From
The Income Statement?"

Here are two important ones.  There are others.

Gross Profit Margin

The formula:  Gross Revenue - Cost of Goods Sold = Gross Profit

                      Gross Profit / Gross Revenue = Gross Profit Margin

Now, our friend Warren, looks for companies that have a Gross Profit Margin of 60% or better. 

Wow!  His standards are so high.

The Gross Profit Margin of the company in our example is:  15,000 / 20,000 = 75%

Earnings Per Share (EPS)

This is one ratio that Warren keeps a beady eye out for. 

But it's not just a figure he's looking for.  He wants to see a steady increase in EPS over a long period (10 years or more).

What Warren Buffett does not want to see is an erratic EPS over a period.  Up one year, down the next, followed by the occassional loss.  He's just not one bit interested in that type of company.

The formula:  Net Earnings / number of shares in issue = Earnings Per Share (EPS)

For our example, our fictitious company has one milliion shares in issue, its EPS is therefore:
                                         3,488,000 / 1,000,000 = £3,49

In practice, this figure on its own is quite meaningless.  What Warren Buffett looks for is a ten year history of earnings.  And in particular a rising trend over that period. 

"Books That Will Augment Your Understanding of The Income Statement"

Here are a few books that have helped us understand company accounts.  Maybe they can do the same for you.

Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark

We have to say, this is a great primer.

This book is so well-written which makes a stodgy subject easy to read and understand.  Not only does the book go into just about the right kind of detail for the private investor but it is specifically written around the methods of the man himself - Mr. Warren Buffett.

If you want to learn and understand anything about company financials, this is a great book to get you started.  Just click on the link below:

Warren Buffett Accounting by Stig Brodersen and Preston Pysh

This book analyses important aspects of company accounts. It covers subjects such as:

1. Methods of calculating the intrinsic value of a company

2. Detailed instructions on how to read The Income Statement, The Balance Sheet, and The Cash Flow Statement

3. How to calculate important ratios enabling you to evaluate any company.

Get yourself a copy of this book by clicking the link below:

Ratios Made Simple by Robert Leach

Understanding financial ratios is a good way of beginning to understand company accounts. 

Finding ratios is easy - simply divide one figure by another, but the really useful information is in the trend.  Comparing one ratio with another over a period can reveal a lot about a company and where it is heading.

Ratios Made Simple covers over 30 different ratios and leaves the reader in no doubt as to the meaning and it's importance in evaluating a company.

You can access a copy of this fundamentally valuable book by clicking the link below:

Magic Numbers by Peter Temple

Knowing all the 33 financial ratios in this volume will not make you a financial genius, no book can do that.  But it does enable you to extract valuable information about the company under study.

The book is written in plain language, ideal for private investors who want a jargon free explanation.

This resource gives dozens of worked examples with real companies.

Get this book AND its later version (see below). You can pick up very good condition used books, as well as new ones, by clicking on the link below:

Magic Numbers for Stock Investors by Peter Temple

This volume is an up-dated version of the previous 'Magic Numbers'.

The book contains 25 ratios covering all aspects of Balance Sheets, Income Statements, and Cash Flow Statements.

Everything that you need to be able to ascertain whether you would be paying over-the-odds for your investments.

Get this volume, and the previous 'Magic Numbers' (see above) by clicking the link below:

Conclusion

There are many more ratios than those covered here.  But ... where do you stop?

The ones described on this webpage are sufficient for your understanding and any "amateur" research you may want to pursue.

We see nothing to be gained by going into detail on such ratios as "staff costs as a percentage of sales" or "directors' remuneration as a percentage of net income."

Should you want to find out more there are many, dare we say, "stodgy", books on the subject. But we do stronly recommend the work of Mary Buffett and David Clark as outlined above.

We have attempted to highlight the main ratios and amateurs, such as ourselves, should find them more than enough to do simple research - you are, after all, looking for trends.

We don't spend too much time, and neither should you, on complex ratios.  You can quite easily get a good picture of a company share by sticking with what ratios are on this website.

If you want to go deeper, then read around the topic.

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