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Investing 101

Step One: Revenue

The revenue figure says a lot about the company, and the first thing you want to do is see whether it has grown over the past few years. If a company experiences an extraordinary percentage growth from one year to the next, check to see if perhaps it has absorbed another outfit and that the figure now represents the two companies combined. To verify your suspicions, look at the cost of goods sold and the expenses reported for selling and administration. If these have increased by the same percentage, then the company has probably expanded through acquisition.

Step Two: Cost of sales

This figure represents the cost of buying, manufacturing and/or preparing the goods and services that the company sells. Unfortunately, there is no uniformity in how this number is determined and no two companies within the same industry will calculate this amount in exactly the same way. However, a particular company’s financial statements are comparative and are supposed to be presented on a consistent basis year over year.

Step Three: Gross margin on sales

Gross margin is what a company has left to pay for its overhead (salaries and rent), financial costs (interest charges), and income taxes. This is the residual when you take the numbers of Step Two and deduct them from the amounts presented in Step One. So you can see that this figure is perhaps the most important number on the income statement. But beware – the problems identified in each of the above steps are effectively transported here.

Step Four: Earnings from operations

One of the first things most investors look for when they consider a company is a steady earnings stream. But many companies, especially those in the high technology sector, do not make any money at all. So in an attempt to make their financial statements more attractive, they disclose a figure that they term “earnings from operations.” This is not to be confused with “net income (loss) for the year” which represents the company’s financial results over the past period. It is rather management’s way of telling the reader what they had hoped the company would have earned had it not been for some restructuring or other costs that resulted in the loss that actually materialized. Beware of this number for it excludes a bevy of costs and magically produces income where there should have been a loss. Find out the expenses that have been left out!

Article ©2001 The Quarterly Dividend
Reprinted with permission