# Analyzing the Income Statements the Right Way with this Walkthrough

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What You Will Learn

• How to analyze income statements to determine business performance
• How to analyze income statements using Crocs as an example

Previously we had a look at the Statement of Cash Flows with AeroGrow and another discussion on Free Cash Flow and points to consider as investors. In this post, let’s take a look at the Income Statement for Crocs (CROX) and try to find warning and other signs.

To help get new investors started, here are some great resources to get you started on the Income Statement

#### Income Statement Analysis Overview

Income Statement Analysis

#### Cost of Goods Sold

When analyzing the income statement, we should always try to compare each line with Revenues as a percentage. As numbers go from 6 figures (millions in revenue) to 9 figures (billions in revenue), it’s easy to lose track of the numbers. Below is a screenshot of how I have my spreadsheet set up.

Straight away we see that Crocs COGS (Cost of Goods Sold) is 98.6% of revenues in its latest quarter. Also keep an eye out for how COGS increases in relation to sales over many quarters. If COGS increases faster than sales, that is a red flag which must be looked into.

#### Margins

If we then move to the gross profit line we have to consider many things regarding margins. Gross margins tell you a lot about a firm’s competitive position. If a company can increase its gross margins, the company is doing two things;

1. cutting production costs or
2. raising prices

Both are good signs and margins that can trend up is always a good thing and will lead to an increase in future earnings.

Unfortunately, for Crocs, compared to a year ago, their margins have jumped off a cliff from an impressive 60% to 1.4% in 3 months ended September 30.  This deterioration could mean that raw and production costs are rising, as evidenced by the increase in COGS compared to 2007.

If production costs increase, the company has to proportionally increase their prices, but do people really want to spend an extra \$5 for an already expensive fad shoe? On the other hand, if a rise in production cost is not the cause, then the company must be cutting prices in order to maintain market share and gain some revenues.

Brad at TMWTFS has stated clearly that a company should never compete on price. Those that do, have no competitive advantage.

Operating margins and net margins also provide vital information about the capabilities of the company. Gross margins could be superb but if operating margins are low, any drop in gross margins could have a material effect on the overall profit of the company. Huge drop in gross margins lead to a loss in operations and subsequently, net margins.

An important note about margins is that we must identify the company strategy before immediately jumping to conclusions. Crocs is an example of a typical company banking on high returns with low inventory turnover to make a profit. Costco, Wal-Mart and other super retailers have small margins yet their inventory turnover is extremely high. The volume of products sold is where the profits come from. So think strategy before dismissing a company completely.

#### Selling, General and Administrative Expenses

For a company doing so poorly, SG&A for Crocs is far too high. High SG&A for any company is a serious problem. This line is also where companies expense the limos, private jets, boats etc used by executives. For a company doing so poorly, as a shareholder you would expect the CEO to take economy.

Companies should try to keep SG&A to a certain percentage of revenues. This prevents future problems caused by hiring sprees and huge bonuses. Costco has been able to keep their SG&A between 8.5-10% for the past 10 years. A clear indication of the quality of management.

#### Impairment Charges

A fancy way of saying “we made some bad decisions which will cost us millions of dollars”. This is not a line in the Income Statement that we want to see. Crocs is writing off \$31.6m from goodwill in the 3rd quarter which is essentially writing off \$31.6m from equity. Another reason why a company with high goodwill should be examined further.

Impairment charges is also another way to evaluate management.

The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to impairment have not made good investment decisions. Managements that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality. – Investopedia

#### Other Income, Income tax, EPS, Shares Outstanding

Footnotes should always be reference to determine exactly what Other Income is. This is evermore true if the number is high.

Income tax and Earnings Per Share (EPS) is straightforward and doesn’t require additional comments.

Shares outstanding should be monitored as well. Always use the diluted number as it includes stock options. Crocs has been buying back its shares from the previous year in an attempt to increase shareholder value but that is a minor point compared to what has been discussed above.

#### Summary

• View numbers as percentages and compare over several quarters and years
• COGS should never be higher than sales
• Margins reflect competitive position and company strategy
• SG&A and Impairment Charges determines the company’s management quality

That is how to properly conduct an income statement analysis.

#### Disclosure

No positions in any stocks mentioned at time of writing.

To get this kind of information and other exclusive articles before regular readers, get on the VIP Mailing List today.

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Want to take the hassle out of finding, detailed number crunching and grading stocks? Streamline the process with an easy to use systematic method so that you can focus on the important tasks. Click here to use the live demo of old school value stock grading and valuation tool today.

### 12 responses to “Analyzing the Income Statements the Right Way with this Walkthrough”

1. Nurseb911 says:

That Income Statement is BRUTAL!!! I’ve never looked at the company, but now I definitely don’t want to.

I think I’ve done a good job of outlining my perspective on “never compete on price” through my two stock analyses of Costco & Coca-Cola. Even though the perception by an investor is that their good/service is “cheap” they don’t sacrifice margins.

In this economic environment it is very difficult for companies to increase revenues and margins are their saving grace. When you compete on price your costs remain the same and revenues fall. Even if they increase over the short-term consumers aren’t very receptive to an increase in price later on. You’re basically just taking money out of your own pocket. McDonald’s learnt this the hard way about 7 years ago and Motorola most recently. Even if you have a sustainable competitive advantage in your margins (Coke vs. Pepsi) why would Coke ever undersell a Pepsi product and take away that additional profit from themselves?

Thanks for the link btw – you’ve had some really good articles lately. Keep up the good work! 🙂

Nurseb911’s last blog post..Mail Bag: Stryker (SYK)

2. Jae Jun says:

I was quite shocked to see such bad numbers myself. It’s something to beware with one product companies. Their margins will become non-existant the minute the economy contracts or they make an error with the product.

Unless you are Tiffany or Chanel, companies shouldn’t even consider raising prices in todays environment.

3. sir says:

old news
i believe all bad news in,i will watch for a rebound during this year.
rsi will be strong above \$5

4. Chris says:

Excuse me SIR,

5. valuegeek says:

I shorted CROX back when it was trading in the \$60s in 2007. Ironically, I ended up losing money because I covered in the \$70s. This is a seriously troubled company. Management is basically a gang of crooks, issuing themselves and selling massive amounts of stock in 2007. The product is not protected by patents (despite claims to the contrary by the company) and easily duplicated by lower cost manufacturers in China, plus the whole rubber footwear craze has the feel of a passing fad. Asensio, a dedicated short-seller, has a report on the stock that is 2 years old, but is still an entertaining read.

valuegeek’s last blog post..Two year anniversary

6. Bearish says:

Nice analysis. I owned CROX for a brief time around \$4, cause it just looked like a screaming bargain based on a crude scan of the numbers. But inventory and the other numbers you pointed out indicate potential trouble.

Bearish’s last blog post..Are banks worried about Obama’s pledge for transparency?

7. sir says:

Chris & valuegeek

there is no different between \$1.4 stock price to \$4 to \$8 for crocs shares after the \$70 share price.
i hope for a nice rebound after the next reports, so i will call you above \$5 when institutionals will buy back crox shares

8. Jae Jun says:

@ Sir
When I look at CROX the business, it isn’t worth \$5. I see a company that should go bankrupt from the way things are going. As for the drop from \$70, all I can say is that price follows value.

Nevertheless, good luck in your position.

@ Valuegeek
One thing I learnt about short selling was that shorts have got to have 2x or 3x the conviction of longs and that shorts never go according to plan. There are too many foolish banks on wall street willing to give their money to failing companies.

9. JJ: excellent educational experience. I like reading your posts that dice and chop financial statements.

Dividend Tree’s last blog post..DBN in my Dividend Growth Portfolio – An Update

10. Jae Jun says:

Thanks Div Tree!

11. tawan says:

Thank you for elucidating some difficult financial concepts. I enjoyed reading your article…

12. Hieu says:

thanks mate!

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