The Income Statement
( Originally Published 1939 )
PROBABLY the most vital part of any company's financial picture is its income statement. Practically every business is organized for the express purpose of making money, and if it fails in that function the business fails. Hence its income statement is of paramount importance. The business cannot survive if its outgo continues to exceed its intake.
The prospective investor of a company, as well as its present stockholders, is vitally interested in knowing the amount of money the company has taken in, from what source it came, the amount which must be paid out, and the amount left for the distribution of its owners, i.e., the stockholders.
The ideal income statement should show all avenues of income which relate directly to the function of its business. If it is an industrial stock, this would be the net sales, less sales commissions, and provisions for doubtful accounts and other allowances.
After this item is set up, then all operating charges should be deducted. This should include manufacturing costs, administrative expenses, selling expenses, inventory adjustments, provisions for depreciation, maintenance, commercial discounts, and all taxes, municipal, county, state and federal. After deducting such expenses you should arrive at the net operating income.
The company, however, may have other income which is not directly related to its business. This income may appear in the form of dividends, interest, or money received from securities sold.
It may also have deductions to be made from other income, and if such other income is insufficient it must necessarily be taken from net operating income. Such deductions would be to deduct interest of all kinds, whether bond or notes. Provisions for depletion should also be made, as in such industries as mining, oils, etc., as well as provisions for depreciation against the day some property or equipment might be withdrawn entirely.
Such an income statement would reflect very clearly the amount of sales, the operating charges or expenses of the company. It would also reflect all other income as well as all other expenses.
By no means, however, do all companies set-forth the information mentioned above in a comprehensive manner, and neither do they employ a uniform system of reporting. As mentioned in previous chapters, the Stock Exchange is endeavoring to secure a uniform method of reporting, and many companies have responded; nevertheless, there is a vast difference in the method employed, even by those who are liberal enough to issue what might appear to be a complete statement.
For instance, the item net sales, as may appear in one income statement, may be expressed entirely different in another. One company might say net sales, and another merely sales, while still another might say net income from sales, and another net operating profit.
Possibly the best method for the amateur investor, or the one unaccustomed to reading income statements, is to devise for him-self a simplified form, and whenever he attempts to analyze a statement, transfer the items to correspond to the form devised. As a model take the form of the Compass Motor Company, which is simplicity within itself.
Total net income 450,000
Total surplus 500,000
Quite naturally, if the Compass Motor Company was showing a deficit from the preceding year, and a deficit during the current year, you would arrive at the total deficit at the end of your statement, instead of the total surplus.
The investor must rely a great deal upon his own initiative in analyzing income statements and balance sheets. That is, he must select the items which are to be consolidated and drop them in their proper places. This is based on the premises, however, that the companies issuing the reports have given sufficient information to enable him to do so. The balance sheets of some of the largest companies in the country appear to be very indefinite and are reported in such a manner that the investor could not possibly classify or interpret their contents.
Assuming that the statement issued is complete, and that the investor wishes to set up for himself a simplified form of balance sheet, just as he did with the income statement, he must take the item of depletion and depreciation, which may be shown in the income statement, and transfer it to the item of fixed charges. While this is not the proper category, nevertheless, for the purposes enumerated, it is better there than in operating expenses.
Depreciation and depletion, however, do not always show in the income statement. They properly belong in the balance sheet, but there are sometimes items of depletion and depreciation that should be reflected in the income statement and not the balance sheet. That this may not appear paradoxical to my advice given in the foregoing paragraph, that of transferring such items to your balance sheet, let me explain more fully.
The maintenance of a piece of machinery properly belongs under operating expenses in the income statement, but from year to year provision should be made against the day when that piece of machinery becomes obsolete and must be replaced. If a piece of machinery costs $10,000, and it is estimated that five years will see it worn out, or obsolete, requiring replacement, then the balance sheet of each year should carry in its depreciation account an item of not less than $2,000.
The assets of a company, which are subject to depreciation, can be classified as its plant, lands, building and equipment. Then follows its inventories. This might be the product it has manufactured and has on hand, or the raw material it may have purchased to convert into the product.
Its securities account follows next. Inasmuch as a decline in the market may seriously decrease the market value of the securities a company carries among its asets, provision must be made in the depreciation account to offset this difference in market value.
Next you come to inventories. A corporation might have on hand, or under contract to purchase, a large quantity of raw material, and they are faced with a declining market. Ample provision must be made for this depreciation in their inventory ac-count, inasmuch as it represents current assets of the corporation.
Depletion is usually something which cannot be replaced. It is the exhaustion of the company's assets. A gold mine, coal mine, oil well, timber tract, and other such properties, are usually considered in the depletion category. As a property exhausts its resources, it should show in its depletion account accordingly. The company deducts from the life-expectancy of the property, or its estimated yield, the amount taken out from year to year. A mining company which strikes a rich vein not anticipated in the original assay, or an oil company, which through scientific methods, has prolonged the life of the property, may have, through their depletion policy, a highly inflated depletion account. This provides an avenue for hidden profits, if the management is so inclined.
In a book of this character it is impossible to treat many subjects as extensively as I would like. Nevertheless, even though we merely touch upon the highlights of such phases of industry, as the company, its management, its corporate set-up, balance sheets and income statements, the investor who grasps and utilizes, even these brief fundamentals, will find himself better equipped to enter the stock market.