Income statement analysis forms the basis of the financial valuation of companies. Investors also rely on a close review of the income statement to make investment decisions. The income statement is, perhaps, the most popular financial statement used by analysts, advisors and investors in their decision-making process, but to apply the correct weight to the information the statement presents, it is important to fully understand what it is designed to reveal. Three of the best tips to keep in mind when reviewing income statements are to know what the income statement is and what it is not, analyze the income statement in conjunction with a cash flow statement and review the notes and comments to the statement before making major decisions based on the numbers.
Businesses are primarily concerned with profitability, because it is an indicator of successful operations and future viability. Likewise, investors are also concerned with profitability, because profits determine their earnings per share. The income statement is one of four standard financial statements that businesses use to evaluate the financial condition of a company. It is the statement that presents financial information in a way that reveals if the company's operations have been profitable.
The income statement presents revenue, also known as sales, and expenses over a specific time period. At the basic level of income statement analysis, subtracting expenses from revenue tells the analyst whether the company is making or losing money. The first tip about income statement analysis is to understand that profitability on paper does not necessarily equal solvency.
It is possible for a business to have sales on the books that it has yet to fully collect. Credit customers can be late making payments, or money can be tied up in inventory that cannot be sold quickly. The bottom line is that a company can look profitable on paper while not having enough money on hand to pay the bills.
This is why the second tip for income statement analysis is to never analyze an income statement in a vacuum. The review should involve a simultaneous analysis of a company's cash flow statement. A cash flow statement presents actual money in and out of the business on a monthly basis, showing whether the company is solvent enough to pay its bills on time. It is very easy for a company to look profitable on paper, while its creditors are forcing it into bankruptcy court for not paying the bills.
Tip number three is to read the notes and comments that accompany the income statement. Although a company can generate financial statement at any time, outside parties rely on statements prepared by independent auditors. The complete report prepared by these specialists includes the auditor's explanations of mitigating factors that were revealed during the audit investigation. Income statements can be manipulated to show profitability that is highly dependent on a speculative future occurrence, such as winning a lawsuit, so a careful review of the auditor's notes can present a more reliable picture.