Today, we return to our analysis of Capital One Financial (NYSE: COF), a credit card and financial services company that's one of the fastest-growing and most profitable card companies in the industry.

In an article two weeks ago, we covered the basics of Capital One's business model: Its information system -- which allows it to test products, screen customers for risk, offer speedy customer service, and cross-sell additional products to consumers who qualify -- provides a competitive advantage. It allows the company to identify and solicit customers who will pay their bills in areas outside the typical feeding grounds of credit card companies, such as the sub-prime sector. The ability to intelligently parse a customer base, to find customers who will create value for the company where others could not, or would not, is the mark of a business with a strong competitive advantage.

I included Southwest (NYSE: LUV), Wal-Mart (NYSE: WMT), and perhaps Dell (Nasdaq: DELL) as companies that had broken similar boundaries. At the end of the article, I suggested Capital One's innovative products could help the company emerge as a consumer brand. This won't be easy in the financial services industry, where most products are about as exciting as tax forms, but the company has changed the credit card landscape with its innovative products. 

Today, I'll try to help you understand how to analyze the company's growth. We took you through the same exercise with American Express (NYSE: AXP) in an article a few months ago. Capital One, as a credit card company, is similar, but there is one twist.

Like most banks and financial services companies, Capital One has two sources of revenue: interest income and non-interest income. Note that in the financial services business, sales (or revenues) are called income. Last year, interest income totaled $2.4 billion and non-interest income totaled $3 billion. Interest income includes interest charges on credit cards as well as late fees, while non-interest income includes just about everything else: annual membership fees, interchange income, overlimit fees, cash advance fees, and cross-sell revenue.

If you want to see Capital One's total income, or total revenue, you must subtract interest expense from interest income (giving you net interest income), and then add it to non-interest income, giving you $4.6 billion. Interest expense is a lot like "cost of goods sold" on a traditional manufacturer's income statement because it includes the cost of raw materials. Money is the raw material that Capital One requires for growth, just as lemons, water, and sugar are the raw material costs for a lemonade stand. Capital One pays interest on the money it loans and profits from the spread between its borrowing and lending rates. It sounds difficult, but it's not too hard to understand if you give it time to sink in.

Here's how these segments of the income statement look:

Capital One                  2000 ($ 000)
Interest income:
  Consumer loans & fees       $2,286,774 
  Securities for sale            $96,554      
  Other                           $6,574 
Total interest income         $2,389,902

Interest expense:
  Deposits                      $324,008 
  Other borrowings              $202,034 
  Senior notes                  $274,975
Total interest expense          $801,017

Net interest income           $1,588,885

Non-interest income
  Servicing & securitization  $1,152,375 
  Service charges & fees      $1,644,264
  Interchange                   $237,777
Total non-interest income     $3,034,416

Total income                  $4,623,301
It's often said that you must know how a company makes money and how it plans to make more money if you want to understand a business. Indeed, this is base camp. But like an aggravating essay question, it has multiple parts and isn't easy to answer. Considering the cost involved in gathering information, investors should use this question as a starting point for their research.

We know how Capital One makes money: It offers credit cards and collects interest and non-interest revenues. If we want to know how the company will make more money, we must know how to track its growth. If you can get through this you'll have a pretty good idea of how to track the company's progress. Therefore, we need to know how Capital One will grow its interest and non-interest income. We'll take them one at a time.

Net interest income is equal to receivables times net interest margin. It's not too hard if you break it down. Receivables -- sometimes called "managed loans" -- represent outstanding balances on credit cards. Remember, receivables for a financial services company are an attractive asset since they represent loans on which customers pay interest. The net interest margin is the average interest rate the company receives on those balances minus interest costs.

Net interest margin moves up and down over time with overall interest rates and average credit card interest rates, but overall it's not a number than can keep growing. Therefore, to grow its interest income Capital One has to grow its receivables. It has to issue new credit cards; its customers must use the cards; and its customers must revolve credit card balances. If it's doing this, it's growing receivables. Here's a look at the company's progress (numbers in billions):

Year     Receivables
1996        $12.8
1997        $14.2
1998        $17.4
1999        $20.2
2000        $29.5

Over the last four years receivables have grown at a compound annual rate of 23%. Capital One's loan growth has kept pace with that of fast-growing rival MBNA (NYSE: KRB) and grown more than twice as fast as Morgan Stanley's (NYSE: MWD) receivables growth for its Discover Card, which increased at a compound annual rate of 9.3% over the same period.    

Non-interest income is the product of account growth and average fees. Like net interest margin, fees just can't keep growing. This means that account growth (i.e., the number of customers) is the number we have to watch. Here's how it looks (numbers in millions):

Year       Total Accounts
1996            8.6
1997           11.7
1998           16.7
1999           23.7
2000           33.8

Over the last four years Capital One has almost quadrupled its number of accounts, growing its customer base at a compound annual rate of 41%. Last year alone, Capital One grew its accounts by 43%, compared to 10.4% for Citigroup (NYSE: C), 10.6% for Morgan Stanley, and 12.4% for American Express.

That's it. Focus on receivables and account growth. If we take these two items and overlay them with the company's information-based strategy -- all the qualitative aspects we talked about in the first Capital One story -- we get a pretty good idea how the company grew revenue at a compound annual rate of 41% since 1995, and earnings 29% over the same period.

Next week, we'll wrap up with a glimpse at Capital One's asset quality (i.e., risk) and growth opportunities.

Have a great day.

Richard McCaffery, who didn't even know that Cassiopeia was the mother of Andromeda, owns shares of Dell Computer. The Motley Fool is investors writing for investors.