In this post, I will be sharing simple tips on how to take a closer look at the income statement (or Profit and Loss Statement) of a business that you are keen on investing. I was lucky enough to learn accounting at the diploma level when I was studying, but you need not necessary be an accountant to know how to analyse financial statements. Let’s get started.
Today we will be using Sheng Siong’s financial statements as a example to analyse its income statement. It is the third largest chain of supermarkets in Singapore. Its financial statements can be found here.
The first part we will be looking at its revenue. What is revenue? According to Wikipedia, it is basically the income a business has from its business activities, usually from the sale of goods and services to customers. It is also known as sales or turnover. The company’s size of revenue for the quarter or full financial year will indicate how big its business operations is. Ideally, you would want to invest in a business whose revenue grows over time. I know it is not possible for cyclical stocks or even some of the defensive stocks in an economic recession but it’s a basic guideline that I use to evaluate companies. As you can see from Sheng Siong’s income statement, revenue increased by 4.2% for 3 months ended 30 Sep 2017 and 5% for 9 months ended 30 Sep 2017. This is due to the opening of new stores recently. So in my opinion, I take that as a good sign.
Cost of Sales (or revenue)
Okay, so the second part we will look at is the cost of sales. It is defined as the direct cost of making the goods or provision of services by a company. Ideally, you would want the cost of sales to be lower than revenue so that the company you had in mind makes a gross profit. Red flags should be in your mind when the company is making a gross loss. In this case, you may have to find out what is the reason behind the loss. Is it due to a temporary situation like a national recession, or is it due to something more permanent like poor industrial fundamentals? For example, the sales of newspapers have been in decline due to the internet and the rise of the digital age. Unless the media industry innovates to take advantage of this current trend, it may soon be obsolete. In Sheng Siong’s profit and loss statement, its cost of sales is less than its revenue for both 2017 and 2016. That is despite its rise by 4.4% and 4.6% in the 3 and 9 months ended 30 Sep 2017.
Gross profit is the profit a business makes after subtracting the costs of producing its goods or supplying its services from its sales or revenue. The formula to calculate gross profit is this:
Gross Profit = Revenue – Cost of Sales
Ideally, you would want your stock to make a gross profit than loss. You would also want your stock’s gross profit to rise over time. In Sheng Siong’s profit and loss statement, its gross profit rises by 3.8% and 6.2% in the 3 and 9 months ended 30 Sep 2017. I take that as a good sign of Sheng Siong’s ability to profit in the marketplace.
This is the business’s other source of income besides the making or provision of goods and services.
Expenses are money spent in generating a profit in a company. Some examples of expenses would be selling and distribution, administrative, marketing and salaries and wages. Ideally, you would want the expenses of a business to decrease over time though it may not be possible if it scales its operations. In Sheng Siong’s income statement, its distribution expenses dropped by 2.9% in the 3 months ended 2017 but actually rose by 10.6% in the 9 months ended 2017. We have to look at the chairman’s or CEO’s opening statements regarding this increase of expenses for the 9 months period.
Results from Operating Activities
According to Investopedia, this is the core business activity that a company does and largely determines if a business is making or losing money. It is generally the major source of a business’s cash flow too. Ideally, you would want the company to have a growing positive profit from its operating activities. You should be concerned when the business is making an overall loss. In Sheng Siong’s profit and loss statement, net profit from operating activities rose by 10.3% and 8.1% in the 3 and 9 months ended 2017. I take that as a good sign.
Profit before Tax
Profit before tax (PBT) is basically the business’s profits before it has to pay corporate tax. This is done by subtracting all expenses from sales including interest and operating expenses with the exception of income tax. This definition is also from Investopedia. As a company’s tax expenses change over time, removing it from its net profit gives a clearer picture of its earnings from time to time. You would also want the PBT of your stock to increase over time ideally. As you can see from the financial statements, Sheng Siong’s PBT rose by 10.7% and 7.3% in the 3 and 9 months ended 2017. So ,overall, Sheng Siong’s business is growing.
Profit for the Period
Profit for the period for a company is the actual profitability of a business after taking into account all sorts of expenses like income tax, operating expenses and other expenses. Ideally, you would want to invest in a company whose profits are growing and positive over the years. For Sheng Siong, profit for the period jumped by 25.3% and 11.8% in the 3 and 9 months ended 30 Sep 2017 so it’s good.
Total Comprehensive Income
According to Wikipedia, comprehensive income is the total of net profit and other items that must skip the profit and loss statement due to them not being realized yet, like foreign exchange gains or losses. Just like profit before tax, you would want your total comprehensive income of your stock to grow over time and remain positive. For Sheng Siong’s case, total comprehensive income leaped by 23.9% and 11.3% in the 3 and 9 months ended 30 Sep 2017. Which is a good sign.
In a nutshell, you would want to put your money in a company whose profits are growing and positive over time. If you see any losses (which can happen to cyclical stocks), you may want to consider if it is worth taking the risk when the company makes a loss periodically. Even the best companies may lose money in a national recession. Therefore, after analyzing the financial statements of a business, you will have to decide if the risk is suitable for you. Always do your research before putting money into a stock. I am not financially responsible for any losses you make in your investment journey.