LOS J, K, and L requires us to:
j. evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement;
k. describe, calculate, and interpret comprehensive income;
and
l. describe other comprehensive income and identify major types of items
included in it
Mere preparation of an income statement or understanding its components is not sufficient for an analyst. He needs to analyze the same and make meaningful interpretations from the same. To do the same, the income statements should be comparable. He needs to understand the following:
1. Common Sized Income Statements
Common sized income statement expresses each item in the income statement as a percentage of revenue. It makes the comparison between two income statements easier by eliminating the effect of size. The format of a typical common-sized income statement is:
Particulars |
Amount |
Revenues / Sale |
100% |
Less: Cost of Goods Sold |
X % |
Gross Profit |
(100 – X)% |
Less: Selling, General, and Administration Expense |
C1 % |
Research and Development Expense |
C2 % |
Advertising Expense |
C3 % |
Operating Profit |
Z1 % |
Add: Net Non-Operating Income |
Y % |
Pre- Tax Income |
Z2 % |
Income Tax Expense |
D |
Net Income |
Z3 % |
The common size statement also helps in analyzing the company’s strategy, as it gives details of percentage expenditure on the different lines of items.
All the items in common-size income statements are expressed as a percentage of revenues except the tax expense; which is expressed as a percentage of pre-tax income.
2. Ratio Analysis
One can also evaluate the performance of a company by conducting a ratio analysis of the same. Using a typical income statement or the common size income statement, an analyst can calculate the following ratios:
a. Gross Profit Ratio = (Gross Profits) / (Net Sales) × 100
b. Operating Profit Ratio = (Operating Profits) / (Net Sales) × 100
c. Net Profit Ratio = (Net Profits) / (Net Sales) × 100
3. Comprehensive Income
a. Total economic benefits to the company can be estimated by looking at the retained earnings for the items other than the owner’s transactions. These changes can be termed as total comprehensive income.
b. According to IFRS, the changes in equity during any period resulting from transactions other than with owners (such as those involving the issue of equity or buyback of shares, etc.) are called total comprehensive income.
c. Total comprehensive income is the sum of net income and other comprehensive income.
d. Other comprehensive income includes:
i. Foreign currency translation adjustments
ii. Unrealized gains or losses on derivatives for hedging
iii. Unrealized holdings gains or losses on available for sale securities.
iv. Defined benefits post-retirement benefits
e. Under IFRS, there is an option to report the long lives assets at fair value using the revaluation model.