How to Analyse Financial Statements: The Income Statement (Part 1)
A Practical guide to Value Investing
The income statement is where you separate the real businesses from the pretenders. A company can fake growth for a quarter or two, but long-term profitability doesn’t lie.
Here’s how to dissect it—using concrete numbers and principles.
1. Revenue: The Starting Point (But Mostly Noise)
Revenue tells you how much money is coming in, but it’s meaningless alone. A company can have $100B in sales and still lose money (see: most airlines).
What matters? What happens after costs.
2. Gross Profit: The First Real Test
Formula: Revenue – Cost of Goods Sold (COGS) = Gross Profit
Gross Margin: Gross Profit / Revenue
Why it matters:
A high gross margin means the company controls pricing (brand power, monopoly, low-cost advantage). Compare to industry peers: The higher, the better.
A low gross margin means brutal competition (commodity business, price wars). Compare to industry peers. Gross margin vary from industry to industry.
Key Benchmarks (From the Book):
Under 20%: Cutthroat industries (e.g., auto manufacturers, steel).
Example: GM (21%), U.S. Steel (17%)
20-40%: Competitive but survivable (e.g., Walmart, Costco).
Over 40%: Strong business (e.g., Coca-Cola at 60%, Moody’s at 73%).
Over 60%: Rare, elite (luxury brands, monopolies).
Warning: If gross margins bounce around yearly, the business has no pricing power.
3. Operating Expenses: Where Good Businesses Stay Lean
After gross profit, companies pay for SG&A, R&D, and depreciation. This is where many fail.
A. SG&A (Selling, General & Administrative Costs)
Good: <30% of gross profit (fantastic businesses).
Acceptable: 30-60% (still competitive).
Bad: >60% (struggling to stay profitable).
Examples:
Coca-Cola: ~59% of gross profit (high advertising, but justified by brand strength).
Moody’s: ~25% (asset-light, high-margin business).
GM/Ford: Often >80% (high overhead, weak pricing power).
B. R&D (The Innovation Tax)
Best case: Little to no R&D needed (Coca-Cola, Wrigley’s gum).
Worst case: >20% of gross profit (tech, pharma).
Example: Intel spends ~30% of gross profit on R&D—great tech, but constant reinvention risk.
Key Insight:
Businesses that don’t need R&D (e.g., Coca-Cola) have more durable profits.
Businesses that depend on R&D (e.g., Merck, Intel) face obsolescence risk.
C. Depreciation (The Silent Profit Killer)
Good: <8% of gross profit (Coca-Cola: 6%, Wrigley’s: 7%).
Bad: >20% (capital-heavy industries like autos, airlines).
Example: GM’s depreciation runs 22-57% of gross profit—a sign of heavy machinery wear-and-tear.
Why it matters: High depreciation means constant reinvestment just to stay in business.
4. Interest Expense (The Debt Trap)
Formula: Interest / Operating Income
What to look for:
<10%: Strong (e.g., Wrigley: 7%, P&G: 8%).
10-20%: Manageable but risky.
>20%: Dangerous (e.g., Goodyear: 49%, United Airlines: 61%).
Key Insight:
Companies with low interest costs usually have little debt—a sign of financial strength.
Companies with high interest costs are one recession away from trouble.
5. Net Earnings: The Final Judge
Formula: Revenue – All Expenses = Net Earnings
Net Margin: Net Earnings / Revenue
Benchmarks:
<10%: Highly competitive (e.g., airlines, retailers).
10-20%: Solid but not exceptional.
>20%: Likely a durable competitive advantage (Coke: 21%, Moody’s: 31%).
Consistency matters more than size:
A company with 10+ years of rising earnings (even at 15% margins) is better than one with sporadic 30% margins.
The Big Picture Checklist
Gross margin >40%? (If not, be skeptical.)
SG&A <60% of gross profit? (Lower is better.)
R&D low or nonexistent? (Avoid heavy R&D if possible.)
Interest costs <15% of operating income? (Debt kills in downturns.)
Net margin >10% and growing? (Consistency = durability.)