You can gain valuable insights into companies by making sense of their financial statements. Let's review the income statement (sometimes called the statement of operations).
The income statement summarizes sales and profits over a period of time, such as three months or a year. It usually offers information for the year-ago period, too, so you can compare and spot trends.
Consider Hershey's (NYSE: HSY ) income statement for 2004. At the top, as with every income statement, you'll find net sales (sometimes called revenues). For Hershey, they're $4.4 billion.
Working our way 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), representing the cost of producing the products or services sold. For Hershey it's $2.7 billion. Subtract the COGS from revenues, and you'll get a gross profit of $1.7 billion.
To find the gross margin, which reflects the costs of production compared to sales proceeds, simply divide the gross profit by revenues. Dividing $1.7 billion by $4.4 billion yields a gross margin of 0.39, or 39%. (It's often illuminating to compare the results with industry peers. For example, gross margin is 42% for Tootsie Roll (NYSE: TR ) , a smaller confectionary company.)
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. Hershey's operating profit is $902 million. Dividing this by revenues yields an operating margin of 20%, revealing the profitability of the company's principal business. Crunching older numbers reveals that Hershey's operating margin is up from 15% several years ago -- a good sign. (Tootsie Roll: 21%.)
Finally, after items such as taxes and interest payments are accounted for, we come to net income, near the bottom of the statement. Hershey's is $591 million. Dividing that by revenues yields a net profit margin of 13%. This number reflects how much of every dollar of sales a company keeps as profit. (Tootsie Roll: 16%.)
Compare all these margins with those from previous years. Increasing margins indicate increasing efficiency and profitability. Check out the margins of the company's competitors. Is the firm more efficient than its peers? Look for significant changes in revenues, SG&A (selling, general, and administrative) expenses, and costs of goods sold.
And, finally, note that margins vary widely by industry. Software companies such as Microsoft (Nasdaq: MSFT ) , for example, tend to have high margins, while retailers tend to have low ones. Wal-Mart (NYSE: WMT ) is proof that a company can do phenomenally well for itself and its investors despite low margins. It just makes up for them with high volume.
Learn more about how to make sense of financial statements in our "Crack the Code: Read Financial Statements Like a Pro" how-to guide (also known as an online seminar). And drop by our Reading Financial Statements discussion board, too, and see what others are exploring there.