In this video, we're going to go into
more depth with respect to analyzing the income statement.
While a lot of attention is devoted to the bottom line,
the net income number itself,
there's also a lot of attention devoted to the top line.
Many analysts put together separate estimates or
forecasts of what sales is going to be in addition to their earnings forecasts.
Many companies' press releases actually start with
the sales number and then talk about the income number later on.
So, there's a lot of attention devoted to sales and rightly so.
After all, sales is the end result of everything we worked for within a company.
We acquire resources.
We develop products and services with the purpose of selling them to somebody.
So the sales number is a big deal.
In addition to being the top line on the income statement,
sales also determines what a lot of the other lines are going to be as well.
That is, the matching principle matches various types of expenses to the sales number.
In many industries, sales is a leading indicator of profits.
That is, sales happens first and profits follow.
This is especially true in a startup or a turnaround situation many companies have,
as an explicit strategy,
let's go in and generate sales even if we're not making money,
build up market share,
achieve some dominance, and profitability will eventually follow.
For all these reasons,
sales also is the line where there's the most potential fraud and manipulation.
So you have to be very careful in looking at the sales line and
try to get as much detail as you can about what went into its calculation.
When we have sales,
it's often very useful to try to figure out how much of
the sales is coming from new products versus old products,
how much of the sales is coming from new acquisitions that we've
made versus what we refer to as organic growth.
To illustrate that, suppose that last year our sales were $10,
and we acquired another firm whose sales last year was five.
And our two firms together now do exactly the same as last year and have sales of 15.
While on our income statement,
let me show our sales from last year 10 and
the combined sales on this year's income statement 15.
It looks like sales just went up 50 percent,
but nobody did anything better than before.
It's just the acquisition that causes this.
In some industries, like in the retail industry,
you actually see statistics called same-store sales that try to address that issue.
That is, this addresses whether or not sales is up because we opened new stores or
bought out some other chain or
because the stores that we have are actually selling more product.
So, more details is a useful thing.
Another way we can think about details is,
we can get detailed information about sales by geographic area or by product line.
The sales revenue number itself is also a function of multiple things.
Sales revenue is a function of sales volume,
as well as sales price.
If it's a foreign sale,
there's also the exchange rate that goes into that number.
So, if we can decompose how much of sales revenue,
is because we sold more product or sold at
a higher price or had a more favorable exchange rate.
That's going to be useful in projecting out sales in the future as well.
For our case firm,
the large nine US-based multinational pharmaceutical firm,
we've seen that sales has not been growing.
Upon further investigation, the reason for that is,
a number of their key patents have run out.
So we would like to look at patents and progress on
patents as key information for projecting future sales.
How quickly do our other existing patents run out?
Management discussion and analysis may talk about that.
Do we have new products that are almost ready to come online?
What's the progress in the regulatory front?
Are we developing new products?
How much R&D are we spending?
So we noted that R&D is up this year.
That may bode well for our future patents and future revenues.
We had a big acquisition this year.
Well, that means sales is probably going to go up just because of that.
Again, that doesn't necessarily mean we're really growing in an organic sense.
Firms are all required to disclose segmental information.
So this is going to give more details about
the sales by geographic area and by product line.
Quality of earnings is an important concept as well.
Not everybody agrees what quality of earnings means,
but it's generally viewed to have three components to it.
One is, is the earnings repeatable or not or is it recurring or sustainable?
Another dimension is the credibility of the earnings number,
how believable are the assumptions that have been made?
And the third one is,
how close is the earnings to cash?
To get more information about the recurringness,
we want to look at the individual line items and see
whether or not we think that this is something that is sustainable or not.
The footnotes will often help explain
more information about the individual line items as well.
So, here we've seen R&D is up.
We've seen some goodwill impairments as examples of non-recurring items.
We see that there is
a large contingent liability associated with an acquisition that presumably will go away,
reasonably quickly as well.
If we look a little closer at the income statement,
we would see that the tax rate that the company is paying has gone down.
It turns out that this is because more of
the company's income is in low tax rate countries.
Is that something we would expect to continue or will
the tax rate go back up if the sales makes changes again?
Credibility of the numbers,
we can get more information about that too.
Companies actually have to disclose,
in their financial statements,
a section called critical accounting policies.
Here they have to list all of the different areas where the accounting that they're doing
requires a lot of subjectivity and judgment
that are big things on the financial statements.
So, what are the big things that are the most subjective?
You've got to discuss each of those issues in your annual report.
You also have to describe, in your footnotes,
more details about all the assumptions that you're
making about how the numbers were put together as well.
Lastly, closeness to cash flow.
The closer the earnings and the cash flow match up,
the more believable the earnings number.
When there's a big gap between earnings and cash flow,
more skepticism is warranted and
more investigation as to the reason for the earnings is appropriate.
So, earnings quality, sales quality,
sales growth, these are all
important things in terms of projecting out future performance.
And if we can get more detailed information about those,
we can do a better job in projecting out how the firm is going to do.
Richard LambertProfessor of Accounting
Christopher D. IttnerEY Professor of Accounting
