4 Tricks To Reading Income Statements
Don’t Listen To Me, But Please, Hear Me Out. #11
Over the past few weeks I blogged about the following:
- How to build wealth via investing in the markets. Most of us won’t be able to build wealth by renting our time, (a.k.a salaried jobs).
- Investing Philosophies: Why Time in the Market & Diversification matters.
- Passive Investing: Why Investing in an Index Fund maybe a good strategy.
- How to Read a Stock table, if you want a bit more excitement and are not happy with just passive investing.
- How to compare stocks using stock table metrics, so that you can narrow down your selection of stock picks for investing.
Today, I’ll show you 4 easy tricks to reading a financial…
Don’t you roll your eyes, and don’t you dare close that browser.
No, wait, come back here.
Yes, you! Come right back.
As I was saying, today, I will show you how to quickly review financial statements so that you can determine if the company is financially health and viable. There’s a video too!
Thank you for not closing your browser. So, I want you to know the basics of reading financial statements because I want you to be able to protect yourself. You don’t have to do all the analysis, just know what to look for and what questions to ask your broker, if you have one, so that you can make informed decisions.
There are 3 main statements:
- Income Statement (IS): Tells you about the profitability of the company.
- Balance Sheet (BS): Tells you about the overall financial health of the company and if they can sustain themselves over a long period in the future.
- Cash Flow Statement (CF): Tells you if they are able to make payroll and other expenses easily or if they have to borrow short term loans from the bank against future revenues so that they can pay their employees, vendors, utilities etc, on time.
Let’s go back to our Sports Sector and look at Nike’s Income Statement
I like the Marketwatch website because they have financials for the past 5 years. The statements have ratios already calculated as well as a very useful trend graph next to each line item, that you can quickly scan.
4 Items to look at in the Income Statement
1. Sales/Revenue: Nike’s Sales Revenue has been growing steadily. So that’s great. 2020 of course is down due to Covid19. Not a huge red flag. You can see the Sales Growth Ratio and it looks good.
2. COGS (Cost of Goods Sold): This is the cost to make a Nike shoe for example. It includes raw materials and labor directly used to manufacture Nike shoes. Naturally, as you increase sales, COGS would go up. However, if a company is efficient, then the rate at which COGS grows will be less than the rate at which its Sales Grows. For example, in 2019, Nike’s sales grew 7.59% but COGS grew only 6.61%. Nike seems to be efficient and therefore increasing its margin or profitability per shoe produced. However, in 2020 Sales declined (4.39%) but COGS only declined by (2.46%). One reason is costs are booked before sales are achieved; in other words, Nike probably sold a lot less than it expected to probably due to COVID19 related store closures.
3. Gross Margin = (Sales – COGS)/Sales. This is a very important figure and companies that can maintain high gross margins will naturally be able to weather competition. If your margins are too high, then of course competitors will try to disrupt you as Jeff Bezos famously said, “Your margin is my opportunity.” Nike has maintained a healthy margin of about 44%.
4. Net Income is the total profit after the company has paid off all expenses including payroll, rent, utilities, interest payments, taxes, etc. Again, we want to see a positive growth trend. 2018 was a bad year for everyone but Nike recovered extremely well in 2019. Although NIKE is profitable with $2.54 Billion in Net Income in 2020, it is significantly down from the previous year due to COVID19.
I have summarized 3 of them: Sales, COGS & Net Income the video below, so you can follow along with me.
Compare Nike and Lululemon
It is better to compare a company’s financial statements against another in the same sector. Let us look at how Nike and Lululemon’s Income Statements compare. Nike’s Fiscal Year is June-May, whereas Lululemon’s Fiscal year is February-January.
Lululemon seems to be consistently outperforming Nike in terms of sales growth. Remember that Lululemon is worth about ~$40 Billion and Nike is ~$153 Billion in market cap. Lululemon is a much younger company than Nike and therefore may have the potential to have higher rates of growth.
Nike’s COGS grew at a much slower pace than that of Lululemon’s. This is good for Nike. Ideally, we want Sales to grow at much higher rate than COGS. Except for 2017, both companies grew their top-line or sales higher than the COGS which is good. This implies they will have better margins and therefore higher Net Income. In 2017, NIKE’s sales grew 5.51% while COGS grew 7.70%. However, the trend is still good for Nike.
Both Nike and Lululemon enjoy good margins, however Lululemon is significantly better and is able to sustain the higher margins over the past 5 years.
Net Income Growth
2018 was a bad year for both Lululemon and Nike but what is interesting is that in 2019, I expected Lululemon to show a higher growth than Nike. Nike grew a whopping 108%. How is that possible? So, I looked at the Income Statement carefully and the reason is Nike had a huge tax payout in 2018. See Chart 5 below.
Nike’s taxes dropped from $2.4 Billion in 2018 to $772 Million in 2019 which massively helped the income growth in 2019.
Putting it All Together
Let us compare how Nike and Lululemon performs across all three ratios as shown in Charts 6 and 7 below.
I like Lululemon better because it has higher margins and seems to have better growth potential. Moreover it seems to be pandemic proof as its income grew 33% whereas Nike’s Net Income fell 37%.
As you can see, it’s not all that mysterious or difficult to quickly scan an Income Statement. You can now very confidently tell your broker what you like or do not like in the IS of a stock he/she is recommending.
Although, Lululemon seems to have a slight edge over Nike, we need to look at the Balance Sheet and Cash Flow Statements too. I will review Balance Sheets in the next blog.