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The income statement: a dynamic “mirror”
Release time:
Mar 15,2022
Source: Compiled from the Investor Education Base of the Shenzhen Stock Exchange
Editor's Note:
In the era of big data, a key challenge facing investors is how to discern the essence of things from a financial perspective and thereby enhance their investment success rate. To help investors improve their financial expertise and sharpen their financial analysis and judgment skills, the Shenzhen Stock Exchange Investor Education Center has specially launched the “Financial Knowledge at a Glance” series of investor education articles. This is the fourth article in the series, intended as a reference for investors.
The income statement: a dynamic “mirror”
Shenzhen Stock Exchange Investor Education Center
The income statement is a financial statement that reflects a company’s operating performance over a specific accounting period. For investors, the income statement is like a dynamic “mirror,” accurately reflecting the company’s current operational results across all aspects.
When examining an income statement, most investors pay the closest attention to revenue and cost of operations at the top of the table, followed by net profit at the bottom. Indeed, revenue provides a general indication of a company’s size, and net profit is one of the key metrics that investors rely on when making investment decisions. However, beyond these two figures, we can also analyze the income statement from various perspectives by integrating other data from the financial statements, thereby meeting the needs of investment decision-making.
I. Multi-dimensional Analysis of Profit
Experienced investors, when examining the profits of an investee company, not only look at the amount of net profit but also, depending on investment needs, strip out non-recurring gains and losses, interest expenses, depreciation, and amortization expenses from the company’s net profit. Such data can typically be found in the notes to the financial statements in listed companies’ annual reports.
Non-recurring gains and losses are defined in the "Interpretive Announcement No. 1 on Information Disclosure by Companies Publicly Issuing Securities—Non-Recurring Gains and Losses (2008)," issued by the China Securities Regulatory Commission. As an important reference for evaluating a company’s profitability, listed companies are required by the CSRC to provide a separate footnote in their annual reports summarizing the non-recurring gains and losses for the entire year.
Non-recurring gains and losses are generally associated with incidental transactions. By deducting them from net profit, we can more accurately reflect the company’s sustainable operating performance and profitability. Typically, non-recurring gains and losses include gains or losses from the disposal of non-liquid assets, incidental tax refunds or reductions, government grants (except those closely related to the company’s normal business operations, compliant with national policy regulations, and continuously received on a fixed amount or quantity basis), fees charged to non-financial enterprises for the use of funds, and enterprise restructuring costs, among others.
In addition to non-recurring gains and losses, when analyzing net profit, factors that are not directly related to a company’s profitability are sometimes excluded in order to reflect its true earning capacity. For example, companies that actively leverage financial leverage typically have higher financial expenses than those adopting a conservative capital strategy. However, this difference is merely the result of the companies’ choices regarding different financing methods and capital structures—and has no direct bearing on their inherent profitability. Comparing profit (or profitability) levels after excluding financial expenses often provides a better basis for evaluating the profitability of different companies as well as their future investment value.
In addition to adjusting net profit data for different companies by eliminating non-comparable factors and then comparing the adjusted net profits, the analysis of profitability among different companies can also be further deepened through the examination of certain financial indicators.
II. Financial Analysis Indicators for the Income Statement
Generally speaking, regarding profitability and operational efficiency, investors can focus particularly on the following three financial indicators:
1. Gross profit margin
Gross profit margin is a reflection of a company’s core competitiveness and can be viewed as the input-output ratio for generating operating revenue. The higher a company’s gross profit margin, the lower its costs required to achieve the same level of revenue, thereby better ensuring its profitability and operational efficiency.
The gross profit margin is a financial metric that lends itself well to comparison. For example, by comparing a company’s gross profit margin with those of other firms in the same industry, investors can gain insight into the investee company’s position within the industry. Moreover, conducting time-series analysis on a company’s own gross profit margin enables investors to track changes in the company’s profitability over time and thereby forecast future trends.
2. Expense Ratio
The expense ratio is an indicator of a company's operational efficiency.
In the process of achieving business growth, companies need to continually expand their brand influence and refine their sales channels—investments that are all reflected in sales expenses. Therefore, the higher the sales expense ratio, the greater the market investment required for a company to generate revenue. This could be because the product is newly entering the market, the brand’s scale and sales channels are not yet fully established, resulting in relatively high upfront investments; or it could be due to the industry in which the company operates being highly competitive and characterized by low customer loyalty, necessitating ongoing market investment to continuously attract customers.
Administrative expenses refer to the day-to-day operating expenditures incurred by an enterprise, such as office rental fees and salaries paid to management personnel in the enterprise’s headquarters’ administrative departments. The administrative expense ratio is an indicator that reflects the efficiency of corporate management; generally speaking, the lower the ratio, the higher the management efficiency. Of course, enterprises cannot simply pursue short-term profits by continuously reducing their administrative expense ratio. Instead, they need to strike a balance between strategic development and management efficiency. To build a competitive strategic development plan, enterprises inevitably need to attract high-level management talent, which will lead to an increase in operating costs. However, the formulation of a sound strategic development plan is precisely what lays the foundation for ensuring the enterprise’s long-term profitability.
3. Return on Equity and Shareholder Return Rate
The return on equity, also known as the net equity rate of return, represents the net profit earned per unit of shareholders’ equity. This metric is an important financial indicator for measuring the efficiency of using shareholders’ funds; the higher the ratio, the greater the level of returns generated from the investment. It is a key indicator that investors refer to when making investment decisions.
Of course, when making investment decisions, investors also need to take into account the stage of development in which a company finds itself. If a company is still in the early stages of expanding into new businesses and its invested capital has not yet generated stable returns, investors may need to place greater emphasis on the growth prospects of these new businesses rather than comparing the return on equity of such expanding companies with that of companies already in a phase of stable development—thus avoiding making inappropriate investment decisions.
Through this article, we have elaborated on and analyzed the various dimensions of profit and related financial indicators, helping investors assess a company’s profitability and operational efficiency from different perspectives. However, when evaluating a company’s profitability, simply looking at its profit performance may not be sufficient for investors to make sound decisions.
To eliminate visual blind spots as much as possible, we recommend that investors also pay attention to another crucial financial statement—the cash flow statement. We’ll provide a detailed explanation of its contents in our next article, so stay tuned.
(Contributed by Yang Jinlu and Xuan Chaonan, KPMG Huazhen Accounting Firm)
(Disclaimer: This article is published solely for the purpose of investment education and does not constitute investment advice. Investors who act upon this information do so at their own risk. The Shenzhen Stock Exchange strives to ensure that the information contained in this article is accurate and reliable, but makes no warranty as to its accuracy, completeness, or timeliness, and assumes no liability for any losses arising from the use of this article.)
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