Analysis of the income statement
Investors can use income statement analysis to calculate financial ratios that can be used to compare the same company from year to year, or to compare one company to another.
For example, you can compare one company's profits to those of its competitors by looking at a number of margin measures, such as gross profit margin, operating profit margin, and net profit margin. Or you can compare the earnings per share (EPS) of one company to the earnings per share of any other to show what a shareholder would get per share if the assets became liquid or if each company distributed its net income.
When you compare each line of the report up and down with the top line (which is income), this is called “vertical analysis”. Each line becomes a percentage of the base figure. This method can be used to simply compare one item to another, for example, to test how each might affect cash flow, or to show how the value of one item compares to the value of any other. This can be useful if, for example, you are looking for a reason why a company took a certain action or where it might have overspent. Investors use this method to take a deep look at a company's current position in relation to metrics such as working capital and total assets.
Horizontal analysis, on the other hand, compares the same indicator over two or more time frames. This method is most commonly used to identify trends. One article can be viewed over a long period of time to see changes from year to year. For example, you may want to clarify what factors may have determined the success (or failure) of a particular company over the past few years. Some investors use this method to predict how well a company will perform in the coming months or years.
Income Reporting Limitations
Since income statements have a number of limitations, they may not always be the best source of information. It depends on what you are looking for. Capital structure and cash flow are just two of the things that can make or break a company, and you need the right numbers.
This is not the whole picture
Although the income statements contain a lot of detail, they do not give a complete picture. The most conspicuous absence is the form that money takes, be it cash or credit. Income statements do not reflect whether sales were made in cash or by credit card, for example, and the same applies to payments. Thus, there is no sure way to determine how much cash can be in the cash drawer at any given time, or how much should come in.
If you have access to balance sheets and cash flow statements, you can fill in the missing pieces.
Lack of exact numbers
Since the income statement is intended to give a complete picture or overview, it often uses approximate numbers rather than exact numbers. To be clear, in order to live day to day and make the right choices, companies may need to act quickly. To function successfully, they need to be able to effectively evaluate broad concepts, or they may need to anticipate future needs in order to make current choices. In these cases, estimates can be very helpful. For example, they often have to come up with a figure to depreciate their assets; after all, they cannot know in advance how long a computer, copier, or corporate jet will last. If they face legal trouble, they will need to determine how much cash to keep in reserve to cover liability,
word of warning
Since the most accurate figures are not always reported on income statements, there is always the possibility of misrepresentation. Whether by design or by accident, the numbers can be skewed. Too high or too low numbers may be used in the income statement, and if you read it, you have no real way of knowing the exact numbers. You also cannot know for sure if there are some insidious motives at work here. While estimates are necessary, and errors can occur without intent, they can also occur intentionally. There are many reasons why a company might want to express an increase or decrease in numbers such as losses or profits, and if it does so without exact numbers to support its claims, then it is fraudulent.
When reviewing income statements, note that companies may differ in accounting methods. Some may use the first in, first out (FIFO) method, while others may use the last in, last out (LIFO) method. This will affect the numbers you can try to compare.