Guides, Resources & Education

Basic Accounting Guide for U.S. Companies – Part 1/3

Find out how to read a U.S. public company's income statement in Part 1/3 of the Basic Accounting Guide.

Learn how to analyse the financial statements of public U.S. companies, item by item.

Introduction

Financial statements – which include the income statement, balance sheet, and cash flow statement – are the richest source of information about a company. Analysing them gives an investor access to crucial facts such as a company’s profitability, its solvency, and cash in and out flows. Public U.S. companies must file their financial statements according to the Generally Accepted Accounting Principles (GAAP), a set of rules that differ from the International Financial Reporting Standards (IFRS) employed internationally. In the U.S., financial statements are typically filed on a quarterly (every three months) and a yearly basis. Quarterly reports are designated by the SEC (Securities Exchange Commission) as ‘Form 10-Q’ whereas annual reports are labeled as ‘Form 10-K’. The financial statements of a company can easily be accessed by navigating to its investor relations website. Once there, you must find the ‘filings’ section and open or download the report of interest, which will bring up an index. Navigate to the item typically designated as ‘financial statements and supplementary data’.

The Income statement

Income statements serve the purpose of indicating profitability. They begin with revenue (the ‘top line’) and deduct various expenses to arrive at intermediary items like gross and pre-tax profit, before finally presenting net income/profit/earnings (the ‘bottom line’). Let’s look at Coca-Cola’s income statement for the fiscal year ending December 31st, 2020.

Source: The Coca-Cola Company Investor Relations Annual Report 2020

We will address each item from the top down. The first item is Net Operating Revenues which describes the total amount of money that the company has taken in during the fiscal year. The second is Cost of Goods Sold (COGS), which refers to the expenses associated with producing a certain product. In Coca-Cola’s case, this may include the costs of sourcing raw materials like sugar and aluminium, and manufacturing costs. Gross Profit is the difference between Revenue and COGS. If we divide Gross Profit by Revenue, we get the gross margin. Expressed as a percentage, gross margin is an early indicator of profitability which only incorporates the COGS and ignores other expenses. It is useful for comparing production costs to sales, so we could use it to compare companies in the same business in an attempt to find the lowest-cost (most efficient) operator.

The item Selling, General and Administrative Expenses (SGA) is typically one of the largest items and it includes elements such as wages and marketing costs. Deducting SGA and Other Operating Charges (a ‘special’ ambiguous item specific to this company’s statement) leaves us with Operating Income. Dividing Operating Income by Revenue gives us the operating margin, which indicates how profitable the company’s core operations are before accounting for taxes and interest. An operating margin of 25% would mean that, for every $1 in Revenue, the company makes 25 cents in profit before taxes and interest. Operating margin is useful because it is a ‘pure’ measure that avoids the distorting impact of taxes and interest – both of which can be highly variable. For example, Company A and Company B, which operate in the same industry, may carry different amounts of debt (more or less interest expenses) and have different tax residencies (different tax rates), so the use of operating margins allows us to control for these influences.

Now, we add Interest Income, which is interest/return that the company receives from investing in safe short-term securities such as commercial paper and treasury bills. We then subtract Interest Expense, which refers to outgoing interest payments made to creditors. Next, we add in Equity Income, which refers to dividends that Coca-Cola receives from its investments in other companies, and Other Income, which describes more atypical sources of income. These could also be losses, in which case we would deduct that sum. Making the above adjustments leaves us with Pre-Tax Income. As with Gross Profit and Operating Income, we can divide Pre-Tax Income by Revenue to obtain the pre-tax margin, which simply indicates the percentage of revenue that is Pre-Tax Income (controlling for tax distortions).

Deducting corporate taxes from this figure yields the. Consolidated Net Income, which describes the income of the parent company (Coca-Cola) and all of its subsidiaries. However, Coca-Cola may not own 100% of all of its subsidiaries, so we need to deduct the Net Income Attributable to Non-controlling Interests. Although this may seem like a complex item, it simply refers to the share of profits produced by subsidiaries that belong to minority shareholders (a minority shareholder owns less than 51% of a firm). For example, the founders of smoothie producer Innocent Drinks, a subsidiary of Coca-Cola, still retain a small number of shares – the profits of which they are entitled to. Netting out this final ‘expense’ leaves the Coca-Cola company with net income/earnings of approximately $7.75 billion for the fiscal year of 2020.

The ‘bottom line’ is subjected to a few more adjustments which produce the items Basic Earnings per Share and Diluted Earnings per Share. Here’s how those items are calculated:

Basic Earnings per Share = Net Income / Average Number of Common Shares Outstanding

Diluted Earnings per Share = Net Income / (Average Number of Common Shares Outstanding + Convertible Securities)

The difference between the two items is that Basic Earnings per Share does not adjust for the dilutive effect of convertible securities such as employee stock options, warrants, or convertible debt. These convertible securities could be exercised and turned (converted) into common shares, which would reduce the entitlement of each original shareholder to the company’s profits (the shareholders are diluted) because earnings are divided among more shares than before. This is why investors pay attention to Diluted Earnings per Share, which divides earnings among all shares – both those in current circulation and convertibles.

Income statements are supplemented by footnotes which shed light on many other data points that an investor could be interested in. For example, in Coca-Cola’s case, we could see exactly what makes up the ambiguous Other Income item and a geographical breakdown of Revenue, as shown below.

A few important considerations apply to income statements. Firstly, companies’ fiscal (financial) years are often misaligned with calendar years. A company’s 2018 fiscal year may end in June of 2019 instead of the last day of 2018, which can be a source of confusion. Companies pick their own fiscal years because they may seek to include seasonal periods of heightened profits in their results. Large retailers, for example, typically report in January so that their statements include the profit-swelling effect of the winter shopping period. Secondly, although all U.S. companies abide by the GAAP rules, there can be significant variation in financial statements as a result of companies being in different businesses. Below, you can see how Barrick Gold’s (a gold mining company) and JP Morgan Chase’s (the world’s largest bank) income statements are structured – notice how different the items are, both relative to each other and to Coca-Cola.

Source: Barrick Gold Investor Relations Annual Report 2020
Source: JP Morgan Chase Investor Relations Annual Report 2020

The variability of income statements provided by companies can be a nuisance to an investor, although the extent of differences varies. Indeed, the two examples above – a mining company and a financial company – represent particularly specialised types of income statements that require expertise to interpret. Knowing the importance of financial statements, it wouldn’t make sense to invest in a company if you do not thoroughly understand them. A third consideration is that income statements employ what is called accrual accounting. This means that transactions are reported as soon as they occur, not when the cash flows actually materialise. For instance, Coca-Cola may have struck a supply deal with a wholesaler who agrees to pay later – the revenue from this deal is nonetheless reported now. Therefore, earnings figures represent both cash income and contractual agreements – an important fact to know. Reconciling these differences, the cash flow statement describes actual cash inflows and outflows. Finally, investors would be wise not to disregard footnotes to the financial statements, which provide valuable detail and insight into certain items on the financial statements. In an upcoming article I will discuss financial ratios, multiples, and what makes a good balance sheet.

Click here to learn how to read a balance sheet

Processing…
Success! You're on the list.

Johan Lunau – 16/06/21

2 comments on “Basic Accounting Guide for U.S. Companies – Part 1/3

  1. Pingback: Basic Accounting Guide for U.S. Companies – Part 3/3 – Lucid Finance

  2. Pingback: A Guide To Value Investing For Novice Investors – Lucid Finance

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: