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IFT Notes for Level I CFA® Program

R21 Understanding Income Statements

Part 4


 

7.  Analysis of the Income Statement

Common-size income statement presents each line item on the income statement as a percentage of revenue. This format standardizes the income statements and helps remove the effects of company size. They are useful to comparisons across time periods and across companies. The income statement is used to calculate income statement ratios to evaluate a firm’s profitability. The commonly used ratios are:

Gross profit margin = Gross profit / Revenue

Operating profit margin = Operating profit / Revenue

Net profit margin = Net profit / Revenue

High margin ratios are desirable. A firm can increase its margins by either increasing selling price or by lowering costs, or both.

An example of a common size income statement is shown below.

2018 % 2017 %
Revenue $100,000 100% $110,000 100%
Cost of goods sold $60,000 60% $65,000 59%
            Gross profit $40,000 40% $45,000 41%
SG&A $10,000 10% $11,000 10%
Depreciation expense $10,000 10% $11,000 10%
            Operating profit $20,000 20% $23,000 21%
Interest expense $5,000 5% $5,500 5%
Earnings before taxes $15,000 15% $17,500 16%
Taxes (10%) $1,500 1.5% $1,750 1.6%
            Net income $13,500 13.5% $15,750 14.3%

Looking at the above common-size statement, we can conclude that, the profitability margins of this company have improved in 2018 as compared to 2017.

8.  Comprehensive Income

Other comprehensive income

Other comprehensive income includes transactions that are not included in net income. Four types of items treated as other comprehensive income under both IFRS and U.S. GAAP are:

  • Unrealized gain/losses from available for sale securities.
  • Foreign currency translation adjustments.
  • Unrealized gains/losses on derivative contracts used for hedging.
  • Adjustments for minimum pension liability.

Besides the items stated above, under IFRS, other comprehensive income includes certain changes in the value of long-lived assets that are measured using the revaluation model rather than the cost model.  Further, under IFRS, reclassification of items from OCI to P&L is not allowed.

Instructors Note:

At Level I, you need to remember the above stated items; these are explained in detail at level II.

Comprehensive income

Comprehensive income measures all changes to equity apart from those resulting from transactions with shareholders (For example, dividends paid and stocks repurchased are not included in comprehensive income.) Comprehensive income is conceptually same under both IFRS and US GAAP. It is the sum of net income and other comprehensive income.

Example

Company ABC’s beginning shareholder equity was $100 million; its net income for the year was $10 million. Cash dividends of $2million were paid to shareholders during the year. The company’s actual ending shareholder equity is $113 million. Calculate OCI.

Solution:

Amount that has bypassed the income statement = OCI = $113 – ($100+$10-$2) = $5 million.


FRA Understanding Income Statements Part 4