Security Analysis Part 2: Analysis of Financial Statements

Chapter 9: Analysis of the Income Statement- General Procedure

This chapter onwards assumes that the reader knows how to read financial statements.

The broad study of corporate income accounts may be classified under three headings:

1) Accounting aspect: "What are the true earnings for the period studied?"

2) Business aspect: "What indications does the earnings record carry as to the future earning power of the company?"

3) Security valuation aspect: "What elements in the earnings exhibit must be taken into account, and what standards followed, in endeavoring to arrive at a reasonable valuation of the shares?"

In order to arrive at the indicated earning power for the period studied, the analyst should follow a standard procedure consisting of 5 steps:

1. He will eliminate nonrecurrent items from a single-year analysis. But he will include most of them in a long-term analysis.

2. He will exclude deductions or credits arising from the use of contingency and other arbitrary reserves.

3. He will endeavor to place the depreciation (or amortization) allowance and the inventory valuation on a basis suitable for comparative study.

4. He will adjust the earnings for the operations of subsidiaries and affiliates to the extent they are not shown.

5. As a check, he will endeavor to reconcile the allowance for income tax with the reported earnings.

Nonrecurrent Items

Nonrecurrent profits or losses are those which arise for reasons outside the regular course of the business. The entries are of 2 main types. In one case the item relates entirely to events taking place in past years, such as the following:

1. Payments of back taxes or tax refunds, not previously provided for, and interest thereon (this may be accompanied by adjustments in depreciation reserves).

2. Results of litigation or other claims (eg. renegotiation, damage suits, public-utility rate controversies) relating to prior years.

The accounting treatment of these entries will vary. It is customary to place them directly in the surplus account, but they sometimes appear in the income statement, especially if they are of minor consequence.

The other type of special transaction has its origin in the year covered by the report but is nonetheless of an exceptional character which sets it off from the ordinary operations. The following are examples of this category:

3. Profit or loss on the sale of fixed assets- or of investments, for a noninvestment company.

4. Adjustments of investments to market value, for a noninvestment company; or write-down of nonmarketable investments.

5. Write-downs or recoveries of foreign assets.

6. Proceeds of life-insurance policies collected.

7. Charge-offs in connection with bond retirements and new financing.

Except for refinancing costs, which are almost invariably charged against surplus, the treatment of these nonrecurring items in annual reports varies widely.

3 suggested rules for the treatment of nonrecurrent items in the income account:

1. Small items should be accepted as reported. For convenience we may define "small" as affecting the net result by less than 10% in the aggregate.

2. When a large item is excluded, a corresponding adjustment must be allowed for the income tax.

3. Most nonrecurrent items excluded from the single year's analysis must nevertheless be included in a statement of long-term or average results.