In week 9, we had introduced the Income Statement, which we agreed provide us the basis to predict the future profitability of the company. In this week, we will try to ascertain what stories the income statement can tell about the operations of a company.
The income statement works like a funnel, you put in the revenue at the top, and out comes the profit at the bottom. As the revenue moves down the funnel, we subtract all kinds of expenses.
The income statement therefore, tells the story of the company’s profitability and the journey the revenue made from its entry point at the top of the funnel until it emerged as profit at the bottom.
While the fundamental logic of the balance sheet is asset equal to liability plus equity, that of income statement as just as simple; revenue minus costs & expenses equals profit.
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In all financial statements, there are notes attached to the items on all the three types of financial statements we will discuss in this class; balance sheet, income statement and cash flow statement. These notes gives additional information on the statement items.
We will use the income statement of a company listed on the Nigerian Stock Exchange, engaged in a business similar to that of Obi & Ada Enterprises as the basis for our discussion.
Looking at the income story above, the first story we hear is about how the revenue (turnover as the company calls theirs) being put into the funnel came about. Note 8 in the financial statement and the description of the activity the company is engaged in will give an insight on the revenue source.
For case study; Obi & Ada Enterprises is engaged in the processing, packaging and sales of agriculture foods, we can therefore categorize their sales revenue to be coming from a single product portfolio. This is unlike a company that may be into beauty products, foods, and some other product portfolio.
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Companies with many product portfolios might split their revenue by product portfolios thereby telling the reader which of the product lines are best sellers. It can also split their revenue by geography, for instance amongst the six geo-political zones in Nigeria, in doing so letting the reader know where the company is earning most of its revenue from.
Why are these stories important? Consider that the revenue of the company is predominantly from Geopolitical Zone A, and the insecurity level in the region starts rising, and turns the region into a quasi war zone, what will that do to the profitability and future of the company?
Furthermore, let us imagine for a minute that the company makes most of its revenue from processed chicken, and there was an outbreak of SARS in the region where it sources its chicken, wouldn’t that impact negatively on the company?
As a Manager in the company, knowledge of these will help you prepare the company for such events. As an analyst, it helps you make sense of the figures before you as you carry out a comparative analysis of the company’s financial reports. As an Investor, it aides your decision on whether to invest in the company or not.
In the same vein, one can go to the notes attached to the cost & expenses items, other income, Financial Income, Taxation and Deferred tax gain to get more information on what these income items are comprised of.
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By just looking at the figures alone, one can see that a bulk of the revenue got taken up by the cost of sales. The cost of sales refers to the direct costs of producing goods by a company. Note 12b breaks down the cost of sales, showing that N437.64 million was spent on raw materials and consumables. Will Obi & Ada Enterprises income statement follow the same pattern?
Yes, it will likely follow the same pattern. If we recall, the business model of Obi and Ada Enterprises is to buy agricultural produce (raw materials) from nearby villages, process and package (processing and packaging materials will make up a bulk of the consumables) them at their facility in the city and sell to customers.
It will be logical to infer therefore that the income statement by virtue of the costs and expenses distribution can give inference on the nature of business the company is involved in; manufacturing or service industry.
There are many other stories heard from the income statement if one pays attention to it. Can you hear any? How important is marketing and advertising to the company, do you think they are in a competitive market?
In our next class, we will look at the last of the financial statements; the cash flow statement.
I enjoy the efforts you have put in this, thank you for all the great articles.