The income statement is one of the most valuable sources of information an investor can have. Yet it is also one of the most ignored. This is because many investors prefer to choose their shares based on the story (and not the financials). But while the story is indeed helpful to get a sense of the company, that story needs backing up with cold hard facts. Cold hard facts that come from the income statement.
When investing in a company, we want to be sure that the company that we are investing in is growing. To check that, we must look at the top-line growth of a company – its revenue. This will tell us if the company is selling more of what it sells or not.
A company that is quickly growing its top-line growth can be very exciting, but revenue is not the be all and end all. For example, I could sell £10 notes all day long for a fiver. It doesn’t mean I’m actually making any money. I wouldn’t be!
Revenue is important, but we also want to look just below revenue at gross profit. Without a positive gross profit then the company is not able to sell its products or services competitively. This is a necessity for any business that we are considering investing in.
Gross profit can also be used to compare with other companies in the same sector. This tells us about the company’s purchasing power and supplier arrangements.
Profit after tax
The next important figure to be looked at on the income statement is profit after tax. This is what is left for shareholders after everyone has taken their cut, including the tax collectors.
It is possible for a company to generate a profit before tax, but have nothing left for shareholders after tax. That’s not good. Very often a company will report the most positive figure in its headlines, so we need to head straight to the financial statements to see the results without spin.
Profit after tax can also be called net income – the income for the company net of all costs and charges. This figure is the one that we use to calculate the price-to-earnings ratio, or the P/E ratio, of a company.
What the P/E ratio does is tell us the earnings multiple of a company. If a P/E ratio of a company is 10, then all things being constant, it will take the company 10 years to earn the profits for shareholders to get back what they paid for the shares.
This is useful for us to get a view of how expensive or cheap the company may be, compared to other companies we may consider investing in.
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