Doc Maher covers some key figures and ratios.
At I’ve said before, the heart of Fundamental Analysis is the ability to understand what the health of a company is. We’ve already covered the Balance Sheet as well as some key statistics like EPS, P/E, and PEG. Continuing with my discussion of financial statements I will turn my attention to the “Income Statement”.
Below are Income Statements for CAT for 2003 through 2007. You can find this on the TradeKing site by gong to the “Quotes + Research” tab then to “Quotes + News + Research”. Enter the ticker for CAT and go to the Financials Tab. The items I will be covering are notated with a green arrow.
Click the image to view the Income Statement.
Jumping right to the bottom line, we can see the total profit or “Net Income” for CAT. This is often called the “Bottom Line” and it is important. However there is a lot more that we can find out about the company’s health in the details of the rest of the statement. There may be little bits of good news or red flags that don’t show up just by looking at the net income.
The income statement starts with “Net Sales or Revenues”. This is the so called “Top Line”. One measure that analyst like to look at is this top line. Are total revenues growing or are they shrinking? This is important because if the top line is not growing where is the growth going to come from? A company may have good and even increasing earnings however if the top line isn’t growing that is probably not sustainable. In the case of CAT we can see that they are growing over the period in question.
The next two lines are basically what it cost the company to produce the products and services that they sold. “Cost of Goods Sold” is a direct cost of materials, labor, etc. The “Depreciation, Depletion & Amortization” is an indirect cost associated with production. For our purposes we’ll lump them together.
Here we have Revenues of $44,958 million minus Costs of $33,297 million leaving a “Gross Income” of $11,661 million. The reason that they calculate the Gross Income is because we are interested in an important ratio called “Gross Margin”. This is a measure of what percentage of the Revenue is Profit after we take out the costs associated with producing it.
In this case we would have 33,297/44,958 = 0.7406. This means that the cost to produce the revenue is 74% of that revenue. Gross margin is the percent that is profit or 1 – 0.74 = 0.259 or 25.9%. Analysts are very interested in the gross margin of a company.
So is 25.9% gross margin good? Well this depends on industry. Caterpillar is in the production of heavy industrial equipment and for that business a gross margin of 25.9% may be good or not so good. We would have to compare them with other similar companies to be sure. I once worked for a company that had 65% gross margin. That sounds really good and it was, However for the industry that we were in it wasn’t way out of line.
If we calculate it for the last few years we can see that it varies a little. If the gross margin was getting smaller that would be a red flag. It would indicate that their costs are going up but that they are not able to pass those costs along in price increases. Ultimately this would put a squeeze on the company’s profit. If their gross margin was going up that would indicate that they have pricing power and their revenue was out pacing their production costs.
The next few lines have to do with costs that are not directly associated with producing the product but they are costs none the less. Of particular interest is the “Selling, General & Administration Expenses.” These are a bunch of costs that have to do with operating the company and promoting the product. The so called “SG&A” costs are also closely watched by analysts. Problems often show up here before they are apparent in the bottom line.
“Operating Income” is calculated by taking out these costs; here it is $6,053 million. Again analysts pay attention to “Operating Margin” which is operating income as a percentage of revenue. Here it would be 6,053/44,958 = 0.135 or 13.5%.
Finally if we look at the net income as a percentage of the total revenue we get the “Profit Margin”. In this case 3,541/44,958 = 7.9%.
These numbers are all calculated for us on the summary page. If you click on the “Summary” tab and then look at the bottom you will see “Key Measures” as shown below:
Click the image to view the Key Measures.
As you can see they have calculated these in the table called “Key Measures” under “Profitability” at the bottom. There are also numbers for “Industry Average”, “Sector Average” and the “S&P 500” for comparison. There are many other Key Measures listed here and we will be examining most of them as this series continues.
Try looking at companies in different industries and comparing their Operating Margin, Profit Margin, and Gross Margin. What does this tell you about the business that they are in?
That’s about all I have space for this time. Next time we’ll look at the cash flow statement. This will help us understand the liquidity of CAT. Liquidity is something we have been hearing a lot about lately so hopefully this will help shed some light on this subject.
"Income Trader"
Doc's previous posts: Level II Quotes: Necessary or a Nuisance? and Three Factors that affect Execution Price
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Jonathan F. Maher, PhD has a professional business relationship with TradeKing.