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Interpreting the Income Statement

How to use financial statements as a management tool, Part 2

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The following is the first in a series of three articles on using financial statements as a management tool. The series references the 2006 annual report from Target Corp. from the retailer's web site. The financial statements begin on document p. 24 (p. 43 of the PDF file).

Like a balance statement, an income statement is a means for measuring a company’s financial performance. Some of the ratios discussed draw data from both the income statement and the balance sheet.

We’ll continue using the published data from Target as an example. Note that all figures represent millions of dollars.

Gross profit margin: The money Target earns from selling a T-shirt, minus what it paid for that item -- known as cost of goods sold, or COGS -- is called gross profit. Sales minus COGS, divided by sales, yields the gross profit margin. According to Target’s income statement, that would be 59,490 minus 39,399, divided by 59,490, which equals 0.337, or 33.7 percent.

Operating income: This is gross profit minus operating expenses minus depreciation. It is also called EBIT (earnings before interest and taxes). Using Target’s data, the formula would be expressed as: 59,490 minus 39,399 minus 12,819 minus 707 minus 1,496, which equals 5,069.

Operating profit margin: Use the total derived in the previous step and divide it by total sales. In this case the equation is 5,069 divided by 59,490, which equals .085, or 8.5 percent.

Interpretation: This tally is also known as EBIT margin and is an effective way to measure operational efficiency. If you find this number to be low, either raise revenues or cut costs. It may help to analyze which of your customers are the most profitable and concentrate your efforts there.

Net profit margin: Net earnings divided by total revenue yields the net profit margin. In this case, 2,787 divided by 59,490, which equals .047, or 4.7 percent.

ROA: This stands for return on assets and measures how much profit a company is generating for each dollar of assets. Calculate ROA by dividing the revenue figure from the income statement by assets from the balance sheet. For Target, that equates to 59,490 divided by 14,706, which equals 4.04. In other words, for every dollar Target has in assets, it is able to generate $4.04 of revenue.

ROE: The same idea as above, but replacing assets with the equity. In this case, 59,490 divided by 15,633, which equals 3.81.

Accounts receivable collection: Many businesses experience a lag between the time they bill customers and when they see the revenue. This may be due to trade credit or because customers are not paying. While you can note this potential revenue in the balance sheet under accounts receivable, if you’re not able to collect it, eventually your business will lack sufficient cash.

Interpretation: To measure how many days it takes to collect all accounts receivable, use this formula: 365 (days) divided by accounts receivable turnover (total net sales divided by accounts receivable). In Target’s case, that equates to 365 divided by the sum of 59,490 divided by 6,194, which equals 38. This means that, on average, it takes Target 38 days to collect on its accounts. If you find your business has a healthy balance sheet but is short on cash, increase collection on outstanding accounts.

Part 1: The Balance Sheet

Part 3: The Cash Flow Statement

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