Factors Affecting the Income Statement

Growth and profitability are the most important factors in determining the value of a stock. It is important therefore to determine the current levels of earnings as well as future prospects. When looking at the income statement one has to look forward in how the various variables can be adjusted and what factors will make them adjust.

Starting with the top of the statement we have revenue, which is price of goods multiplied by quantity sold during the accounting period. So a natural question to ask is can the company raise prices? In terms of microeconomic theory what is the price elasticity of demand of the goods. If the price is inelastic, this means that the company can raise prices without affecting demand (quantity sold) as much and thereby increase revenue. Factors that determine this are competition, product differentiation and consumer tastes. The greater each of these variables, the more power the company has to increase pieces.

We than ask can the company increase output. Gross profit will go up if profit margins don’t change as output increases. For a profit maximizing firm output should increase until the marginal revenue of goods sold =marginal cost of the goods.

What are the companies’ prospects for cutting cost? Cutting costs will eventually increase the bottom line and thereby increase profit margin. Cost cutting can be done by having a more efficient supply chain, a more efficient management structure or simply eliminating inefficient divisions or even subsidiary companies. Cutting costs will lead to higher profit margins which are expressed as

Profit Margin = Net Income (Profits)/ Cost of Goods Sold (Expenses)

Find out if net income is affected by one time expenses. Are the so called one time expenses occurring more often than just once in say ten years or more frequently? Furthermore if the company makes money or has an unusual “one time profit” what do they do with the excess cash? How efficiently do they invest it? Do they engage in buybacks? What are the growth prospects of the company? Find out what measures the company is taking to gain competitive advantage in the industry. What new products are they coming out with? How are they marketing the new product? These all have implications in the growth prospect, and increasing demand for the products.

What are insiders of the company doing? Insiders probably know the company better than anyone else as they are involved in the management of it (however it is important to note that just because an insider is selling a stock doesn’t mean that it is having problems, as insiders very often have to sell their stake to raise cash for personal use etc.). Also find out what the companies clients are doing. This has huge implications on futures earnings, Find out what the client concentration is. This information is available in the 10-K.

Balance Sheet Factors Assets