Before we get into the metrics, let’s explore the following scenario. Imagine that you own an automotive parts store. Business is great, in fact, your business is doing quite well, and you have a lot of customers. Just down the street however, you have a major competitor… a big chain O’Reilly Auto Parts store. They also seem to be doing very well and you’re curious just how well. You’re in luck because all of O’Reilly’s audited financial statements are posted online for public review. Let’s review a P&L (Statement of Income) and 5 of the key metrics that I like to review.
What is an Income Statement
There are three financial statements that are used to present a company’s financial performance over a particular accounting period: (i) balance sheet, (ii) income statement, and (iii) cash flow statement. Combined, these three financial statements reflect the company’s assets and liabilities, profits and expenses, and cash flow from investments, operations, and funding activities.
We will focus on the income statement. An income statement, also referred to as a Profit and Loss statement (P&L), shows how much money the business made or lost during a period – usually over a quarter or for the entire year.
Note: A quarter is any three-month period set on a company’s financial calendar that guides when they will complete their financial reports and pay dividends. The dates can vary for each company, so familiarize yourself with company’s quarters. The quarters are divided like so: Q1: January, February, March; Q2: April, May, June; Q3: July, August, September; Q4: October, November, December.
The Components of the Income Statement
If you’re familiar with Income Statements then Click Here to skip the boring stuff.
At the top of the Income Statement, you will find the company’s Revenue (gross sales) section; further down the Costs (expenses) are listed and eventually you’ll see the Profits (Net Income) at the bottom (bottom line).
The Net Income is the company’s Revenue minus their Expenses:
Revenue – Expenses = Profits (Net Income)
Here’s an example of the O’Reilly Automotive (ORLY) Income Statement – Year 2015 through 2021.
Reading and Defining an Income Statement
- Revenue (Top Line): The Revenue (top line), refers to the gross sales or total revenue of the company. Some companies have multiple lines of business, so there will be a drop-down selection for the various types of business.
- Cost of Goods Sold (COGS): The cost of goods sold (COGS) is the total sum of all direct cost of materials, products, or inventory necessary to make a product or service and create revenue.
Gross Profit = Revenue – COGS
- Sales, General & Administrative (SG&A), R&D, Marketing Expenses: Sales, General & Administrative expenses (SG&A) include a company’s everyday operating expenses that are not included in the production of goods or delivery of services. Typical SG&A items include things such as rent, employee salaries, advertising and marketing expenses and distribution costs.
- Earnings Before Interest, Tax, Depreciation, Amortization (EBITDA): The earnings before interest, taxes, depreciation, and amortization (EBITDA) formula is used when determining the earning potential of a company. When calculating EBITDA, you would remove items such as debt financing, depreciation, and amortization (D&A) expenses to calculate a company’s profitability.
- Depreciation and Amortization: There are two methods used to calculate the value of a company’s assets over time:
- Amortization is the process of spreading an intangible asset (have no physical substance, examples: trademark, branding, copyrights) to expense over a period of its useful life, which shifts the asset from the balance sheet to the income statement.
- Depreciation is a scheduled gradual reduction of a tangible asset (physical property, examples: machinery, building, land) over its useful life and charging it to expenses. The depreciation is applied to fixed assets (useful life greater than one reporting period, examples: machinery, vehicles, furniture, computer equipment, buildings, and other equipment) which have a loss in their utility over the years.
- Operating Profits: The operating profits are a sum of its total earnings from its business functions, excluding the deduction of interest and taxes, and profits earned from additional investments.
Operating Profit = Revenue – Operational Expenses – Cost of Goods Sold – Day-to-Day Costs
- Net Income: The Net income (NI) is known as the “bottom line” of a company, as it appears as the last line on an income statement once all taxes, interest and expenses have been subtracted from revenues.
Revenue – Taxes, Interest, Expenses = Net Income (bottom line)
- Earnings Per Share (EPS): Earnings Per Share (EPS) is the difference between a company’s net income and preferred dividends, divided by the average number of outstanding common shares. EPS is sometimes known as the bottom line of a company’s worth. The EPS number can also navigate investors and provide them an idea of a company’s financial performance.
The Earnings Per Share of a company is the difference between a company’s net income and preferred dividends, divided by the average number of outstanding common shares.
PS. I’ve included a cheat sheet at the end if you need it to review.
5 Key Metrics
In order to dig into a company’s key metrics, it’s important to view multiple time periods – not just one. There’s an endless number of metrics that can be discovered from an Income Statement, across all different time periods, but we will review 5 metrics that I find useful.
Metric #1 | Revenue Growth
I want to see Year over Year (YoY) growth. A healthy company should be growing consistently over time, say 6%-15% is a great example of consistent growth. There are exceptions in a downward economy, but even then, we need discover the implications. Let’s look at O’Reilly’s YoY. Over the last 6 years, their top line has grown from $7.97B to $13.33B – that is a Compound Annual Growth Rate (CAGR) of 8.9% – which is quite healthy.
But don’t stop there, or you might be easily misled by your first glance at the YoY. Growth must also be accompanied by good returns on capital; meaning as the company grows, it will be deploying its additional capital, and that capital must be utilized properly to scale. If a particular market is not growing at the same rate the company is growing, then deploying more capital into the same market can reduce the value for the owners.
Metric #2 | Share Dilution
It’s common practice for a company to issue shares and give them to employees as compensation – Share Based Compensation (SBC). This motivates, encourages, and provides incentives to employees to improve their performance with a shared interest (stock price), but it also dilutes the existing shares – lowering the value. This is notoriously common in growth and tech startups and can have a profound effect – so you will want to be mindful of this practice and keep an eye on this.
You can see on the Income Statement that O’Reilly’s average basic shares outstanding decreased from 73.82 million shares in 2020 to 68.97 million shares in 2021 and their diluted shares outstanding decreased from 74.46 million shares in 2020 to 69.61 million shares in 2021. The shares have been decreasing every year for the last 7 years. This is because the company has been buying back shares each year. To find out more detail on where they are going, we can look at their Cash Flow Statement to see if they are going toward compensation or if the stock were retired. From there we can see $2.48B repurchased and $84.92M issued with the net result is -$2.39B in retired stock. For more details you can investigate the 10-K filing.
10-K is short for Form 10-K, is filed with the Securities Exchange Commission (SEC) and requires all public companies to file each year. The form provides detail of the company’s revenues, assets, and liabilities for the previous year. Some may view stock buy backs to increase shareholder value, while others may view it as an improper use of capital especially when looking at growth. One may ask why they aren’t using the excess capital for growth.
Metric #3 | Debt Coverage
Being able to comfortably cover debts AND interest over periods of time is critical to the growth and longevity of a company. We can take a look at the 10-K to see upcoming maturities.
Sure enough, $300M will be due in 2022 along with the interest. O’Reilly can easily cover the debt repayment in addition to interest on future debt. The company had a net income over $2.16B in 2021 and they have $363M of cash from the previous 2021-year end. But this isn’t the case for every business.
Be cautious with this logic and looking at net income and profits. In order to fully understand how much money is remaining at the end of the period, we must look at the Cash Flow Statement.
Metric #4 | Gross Margins
Typically, a company buys raw materials and/or goods from suppliers and sells the finished goods to customers. In order to maintain growth and stability, the company needs to have negotiating, and pricing leverage. Supplies can vary from time to time and it’s important for the business to have customers that are also willing to bare these costs. So, let’s look at this formula:
For 2021, O’Reilly has a Gross Margin of 52.67% which means for every $1 it has ~$.53 Gross Profit. And over the last several years it has maintained ~50% gross margin. This tells us the negotiating and pricing power of O’Reilly has been very stable leading to a predictable outcome.
The gross margin varies for every company so there is no standard. The thing you want to watch for is that it’s stable or improving, and if it’s not, discover what has led to this change.
Metric #5 | Operating Leverage
Operating leverage is a formula used to find the break-even point (BEP) and to determine pricing that will generate more of a profit. What this describes in most cases is that a company has a set of fixed costs and variable costs that don’t move as quickly as the revenue once the break-even point is achieved. So once the revenues meet the break-even point, the profits will accelerate rapidly at a faster rate than the total costs. Note: this is a double-edged sword and could go the other way. If revenues drop — then the profits reduce at an accelerated rate.
Example
Let’s review the following scenario. A simple way to describe this is with a hotel. Let’s say the hotel has 100 rooms and the break-even point for the hotel is to sell 60 rooms at $100. Most of the costs associated with the hotel are fixed costs, such as real estate, staff, and utilities. When the hotel can sell over 60 rooms it will make a profit. If it can then sell all 100 rooms consistently and eventually raise the price, it will reach optimal operating leverage.
O’Reilly has consistent costs – retail locations and inventory. Both of these costs are variable, so the rate of acceleration is minimal. As you can see the difference in Revenue, Pre-Tax Income, and Net Profit, there is a rising CAGR, but not by much.
Operating leverage can have a profound effect on growth with a company that his fixed costs. This is relatively common in Software as a Service (SaaS) companies. SaaS is a company that hosts an application and makes it available to customers online. They have marginally fixed costs associated with developing and selling the product, but once the product has a steady growth in users, the profits accelerate. Note: Some caution should be taken here. If there is a sudden decline in users below the break-even point and the company has scaled for growth, it can have a huge impact on the company’s ‘bottom line’.
Publicly traded companies that fall into this category will typically have the highest price/earnings ratio (P/E ratio) as investors are anticipating getting in early while the company grows its revenues and begins to have accelerated profits. The P/E ratio tells investors how much a company is worth.
Closing Notes
There are a variety of accounting nuances to be aware of when analyzing the Income Statement. Two common ones are (i) customer acquisition costs, and (ii) Research & Development (R&D) for new products that will launch. These are expensed right away as opposed to depreciated making actual profits appear to be understated. This is something that must be tracked to have an accurate accounting of actual profits and expected future profits.
Conclusion
In summary, these are the 5 Key Metrics that you’ll want to review when analyzing an Income Statement:
- Revenue Growth – at what % is the company growing?
- Share Dilution – Is share based compensation and/or buybacks benefiting shareholders?
- Debt Coverage – Will the company be able to cover upcoming debt payments?
- Gross Margin – What is the company’s ability to keep steady margins through rocky economic times?
- Operating Leverage – Is the trajectory of the operating leverage feasible, and is there a sound plan in place?
Keep in mind that these aren’t the only metrics to review and there are many others that can be used as well. If there are any metrics that you would like for me to write about, please feel free to share them.
Income Statement Cheat Sheet
