Hi again…in the last post we covered the earnings per share component on the income statement and its calculation under different capital structures. In this post we cover a income statement presentation format called the common size income statement and Comprehensive Income component of Owner’s equity. So let’s begin….
Common size Income Statement: How to read and interpret one
Common size income statement is a vertical presentation of the income statements wherein each item is presented as a percentage of the revenue. (See this former post for income statement example). Likewise the vertical presentation of the balance sheet is called Common size balance sheet and that of a cash flow statement is called Common size cash flow statement. Vertical presentation standardizes the financial statements and allows for better comparison of the company’s results over time and also the comparison of a company’s results with that of another company.
Please refer to the below income statement and common size income statement example.
|Income Statements for companies A and B|
|Cost of goods sold||10,000,000.00||1,500,000.00|
|Selling and administrative expenses||2,000,000.00||500,000.00|
|Research and Development||3,000,000.00||1,000,000.00|
From the above income statements for companies A and B we can see that company A’s revenues and gross profit is much larger than company’s B in absolute terms. Also its research and development and advertising spends are much larger than that of B.
|Common size Income statement example|
|Cost of goods sold||50%||30%|
|Selling and administrative expenses||10%||10%|
|Research and Development||15%||20%|
However, when we present the same results in common size format, we can see that the gross profit of A is much smaller than that of B. Also A spends less than B on research and development and advertising as a percentage of revenue. This could be the reason that B enjoys better brand awareness and is able to produce technologically superior products than A at lower costs and sell them at better prices which leads to higher profits.
Although all items on the common size income statement are presented as a percentage of revenue, tax expense is presented differently. It makes more sense to present the tax expense as a percentage of pre-tax income. The resulting percentage is called as the effective tax rate.
Income statement ratios
The two main ratios on the common size income statement are the profitability ratios viz. gross profit margin and net profit margin.
Gross profit margin is the gross profit as a percentage of revenue. It shows the percentage of gross profit earned for every dollar of revenue. Amount of gross profit depends on two factors, sales and cost of goods sold. Gross profit will be higher if the sales revenue is higher and cost of producing the goods sold or cost of goods sold as it is known, is lower.
Sales revenue could be higher and cost of goods sold could be lower if the company spends on research and development to produce technologically superior goods at lower costs. Sales revenue could also be higher if the company spends on advertising for creating more brand awareness leading to higher sales. However these two costs are not included while calculating gross profit though they have a direct bearing on sales revenue.
The other profitability ratio on the common size income statement is the net profit margin. Net profit margin is the net profit as a percentage of revenue. Higher net profit margin means higher profit after deducting all expenses for each dollar of revenue earned and therefore is more desirable.
The other two ratios on common size income statement are operating profit margin and pre-tax margin. Pre-tax margin is the income before tax as a percentage of revenue.
Comprehensive Income is a component of Owner’s equity on the balance sheet and includes ‘Retained Earnings’ and ‘Other Comprehensive Income’.
Comprehensive income is basically all changes in equity from non owner sources. Therefore, Owner’s contribution and distribution to owners is not included in Comprehensive income. The net earnings from the income statement retained by the company for ploughing back into the business gets included in Comprehensive Income and therefore Owner’s Equity through the Retained earnings. The revenues and expenses that are not included on the income statement but affect the owner’s equity nonetheless are included in Other Comprehensive Income. Other comprehensive income includes;
- Foreign currency translation gains and losses
- Adjustments for minimum pension liability
- Unrealized gains and losses from hedging using derivatives
- Unrealized gains and losses from available-for-sale securities
Unrealized gains and losses from securities are either included in the income statement or in other comprehensive income depending on how they are classified. If the security is classified as Trading Securities, i.e. securities being actively traded, the unrealized gains and losses from them are included in the income statement. If they are treated as available-for-sale, i.e. the company does not intend to hold them for long, then their unrealized gains and losses are included in other comprehensive income.
With this we come to an end of this post…thus in this post we have learnt about common size income statements and the different income statement ratios presented on them and we have rounded up are reading with comprehensive income…
in the next post we move on to understanding the basics of the next financial statement i.e. balance sheet…tune in again then….bye
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For solved examples please refer to the CFA Institute books or CFA study notes that provide them. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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