In the Margins

If you're new to investing, you've probably stared at an income statement (sometimes called a statement of operations) and scratched your head, wondering what it's telling you. Let us help.

First, understand that the income statement summarizes sales and profits over a period of time. It might cover three months or a year, for example. It will usually offer information for the year-ago period as well, so you can compare the two and spot trends.

Let's look at Eskimo Pie Corp.'s income statement for fiscal year 1998. At the top, as with every income statement, you'll find net sales (sometimes called revenues). For Eskimo Pie, they're $63.5 million.

From now on, as we work down the income statement, various costs will be subtracted from the revenues, leaving different levels of profit. The item you'll find just under revenues is "cost of goods sold" (abbreviated as COGS and sometimes called cost of sales), which represents the cost of producing the products or services sold. For Eskimo Pie it's $37.4 million. Subtract the COGS from revenues, and you'll get a gross profit of $26.1 million.

To find the gross profit margin, simply divide the gross profit by revenues. $26.1 million divided by $63.5 million yields a gross margin of 41 percent. (Compare results with industry peers. For example, gross margin is 35 percent for Ben & Jerry's, which has a somewhat different business model.)

Next, the remaining costs involved in operating the business, such as support staff salaries, utility bills, and advertising expenses, are subtracted, leaving the operating profit. Eskimo Pie's operating profit is $1.8 million. Divide this by revenues, and you get a slim operating margin of 2.8 percent. This reveals the profitability of the company's principal business. (Ben & Jerry's: 4.3 percent.)

Finally, after items such as taxes and interest payments are accounted for, we come to net income, near the bottom of the statement. Eskimo Pie's is $0.8 million. Divide that by revenues and you get a net profit margin of 1.3 percent. (Ben & Jerry's: 3 percent.) The last part of the income statement is where the company divides its net income by shares outstanding, to arrive at earnings per share (EPS).

That's it!

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Return on Assets

We've all heard the term "capital-intensive," and we all have an idea of what it means. A steel company is capital-intensive, requiring a lot of costly equipment in order to generate its earnings. Software companies typically have a much lighter business model. Once the software has been developed, it's simply a matter of copying it onto disks, packaging it, and marketing it.

Investors can measure a company's asset-heaviness by calculating its return on assets (ROA). There are a few steps involved in this, but they're not too tough. (Got your pencil ready?) You'll find all the numbers you need on a company's recent balance sheet and income statement. We'll use Wal-Mart's fiscal 1999 results as an example.

Return on assets is determined by multiplying net profit margin by asset turnover. To get net profit margin, look near the bottom of the income statement for net income and divide that by net sales (also called "revenues") from the top of the statement. Dividing Wal-Mart's net income of $4.43 billion by its net revenue of $139.21 billion (yowza!), we get a net profit margin of 0.0318, or 3.18 percent.

Asset turnover is calculated by dividing net revenue by the average of total assets for the period. (Total assets are listed on the balance sheet.) Since the revenues we're using cover all of fiscal 1999, we'll add the total assets from this earnings report to those from a year ago, and we'll divide by two. Dividing Wal-Mart's revenue by its average total assets of $47.33 billion yields an asset turnover of 2.94. In other words, Wal-Mart generates nearly $3 in sales from each dollar of assets. Not bad, especially next to Kmart's asset turnover of 2.43.

Now that we have a net profit margin of 0.0318 and an asset turnover of 2.94, we multiply them to get a return on assets of 9.4 percent. This shows that Wal-Mart creates 9.4 cents of earnings from each dollar of assets. By comparison, Kmart's ROA is 3.7 percent.

These are just some of the measures to examine when studying a business. They tell you a lot about how much value the company is creating for shareholders.