MBA in a Nutshell #21 - Accounting and Finance : The Income Statement

Today we will meditate upon the Income Statement.

The most important relationship within an income statement is simply :

Gross income - Total expenses = Net Profit (loss)

It is obviously not so simple :

Operating income = Sales - Expenses, expenses being cost of goods sold, sales and general expenses and depreciation.
Income before taxes = Operating income - interest charges
Net income (loss) = income before taxes - provision for taxes

From an internal management perspective, this is a precious data on how to improve the bottom line :

• Can we improve sales by marketing harder ?
• Is the rise in cost of goods outstripping inflation ? Can we negotiate harder with suppliers ?
• Are general expenses increasing faster than inflation ? Can we cut down on labor costs by outsourcing ?
• Are we reducing depreciation by playing with accounting rules ? Are we depreciating more because of more equipment we are buying ?
• Can tax and interest payments be optimized further ?

These are actually questions an investor can ask when they drill into a company's financial statements. But this is much harder for an investor who has 50-60 counters to manage, many are investments with conglomerates that have a finger in every pie and therefore hard to analyse.

Investors however can piggyback on analyst reports and have someone else analyse the numbers full time for them. 

I've always been wary of investment styles that drill so deeply into company statements and ignore the overall picture of portfolio construction. Even if you can outperform the markets, the lack of diversification means that you will suffer crippling losses if you do not foresee an inflection point coming.