Warning Signals in Income Statement
This is by no means an exhaustive list, but any one of the signals could mean there is a problem. The more warning signals there are, the higher the risk.
1. Is operating profit low, falling or is there a loss?
- Revenue: Look at the company’s revenue to see if it has decreased or if there has been a decline in sales.
- Costs: Analyze the company’s costs, including cost of goods sold and operating expenses, to see if they have increased or if they are out of line with industry averages.
- Gross margin: Calculate the gross margin by subtracting the cost of goods sold from revenue. A decreasing gross margin can indicate that the company is having difficulty controlling costs or pricing its products effectively.
- Operating expenses: Look at the company’s operating expenses, including SG&A, R&D, and others, to see if they have increased or if they are out of line with industry averages.
- Capital expenditures: Analyze the company’s capital expenditures to see if they are in line with the company’s growth plans and if they are being used to generate a return on investment.
- Other income statement items: Look at other items such as impairment charges, foreign exchange gain or loss, and provisions.
- Balance sheet: Look at the company’s balance sheet to see if it has enough cash and liquidity to sustain its operations.
- Cash flow statement: Analyze the company’s cash flow to see if it is generating enough cash to fund its operations and growth.
2. Is profit volatile?
If a company’s profit is volatile, it means that the company’s income and earnings are fluctuating greatly from period to period. This can be caused by a number of factors, such as:
- Volatility in revenue: The company’s revenue may be subject to significant fluctuations, such as seasonal changes, changes in demand, or changes in pricing.
- Volatility in costs: The company’s costs may also be subject to significant fluctuations, such as changes in raw material prices, changes in labor costs, or changes in currency exchange rates.
- Volatility in gross margin: The company’s gross margin may fluctuate depending on the relationship between revenue and costs.
- Volatility in operating expenses: The company’s operating expenses may also be subject to significant fluctuations, such as changes in marketing or R&D spending.
- Volatility in capital expenditures: The company’s capital expenditures may also be subject to significant fluctuations, such as changes in expansion plans or investments in new equipment or facilities.
- Volatility in interest rates and foreign exchange rates: The company’s profit can be affected by the changes in interest rates and foreign exchange rates.
- Volatility in economic conditions: The company’s profit can be affected by the economic conditions of the country or region in which it operates.
Volatility in profit can make it difficult for investors and analysts to predict a company’s future performance and make informed decisions about the company. A company with volatile profits may be viewed as risky and may have trouble raising capital or attracting investors.
It is important for the management of the company to be aware of the cause of the volatility and implement measures to reduce the volatility. For example, by diversifying the business, hedging against currency or commodity price fluctuations, or investing in new technologies or products to reduce reliance on certain revenue streams.
3. Has change in accounting policy been responsible for improving reported profit or minimising loss?
A change in accounting policy can potentially impact a company’s reported profit or loss. Depending on the nature of the change and the circumstances under which it is made, it can either improve or minimize the reported profit or loss.
If a change in accounting policy results in a more favorable or conservative recognition of revenue or expenses, it can improve reported profit. For example, a change in the method of revenue recognition from the accrual basis to the cash basis can result in revenue being recognized sooner and therefore increase reported profit.
On the other hand, if a change in accounting policy results in a less favorable or less conservative recognition of revenue or expenses, it can minimize reported profit. For example, if a company changes its method of depreciation from the accelerated method to the straight-line method, it will result in lower depreciation expense and therefore lower the reported loss.
It’s important to note that a change in accounting policy should be made only if it will provide a more accurate representation of the company’s financial position and performance. A change in accounting policy should be applied consistently and should be disclosed in the financial statements along with the reasons for the change and its impact on the financial statements.
It’s also important to keep in mind that a change in accounting policy alone may not necessarily improve the reported profit or minimize the loss, but it’s important to investigate the underlying reasons of such change, and the management’s plans to address the issue that the change is trying to fix.
4. Do “unusual” items recur?
Unusual items are infrequent or non-recurring events or transactions that are separately disclosed on the income statement. These items can be either gains or losses and can have a significant impact on a company’s reported profit or loss. The concerns if unusual items incur in the income statement are:
- Lack of comparability: Unusual items can make it difficult to compare a company’s financial performance from period to period because they are not recurring in nature.
- Misleading information: Unusual items can make a company’s financial performance appear better or worse than it actually is. This can be misleading to investors and analysts, making it difficult for them to make informed decisions about the company.
- Difficulty in forecasting: Unusual items can make it difficult to predict a company’s future financial performance because they are not expected to recur.
- Difficulty in understanding: Unusual items can be complex and difficult for investors and analysts to understand, which can make it challenging for them to assess the company’s financial health.
- Lack of transparency: Unusual items can make it difficult for investors and analysts to understand how a company is generating its income and profits.
It’s important for the management of the company to be transparent about the nature and impact of any unusual items in the financial statements and provide a clear explanation of the reasons for the unusual items. It’s also important for management to be able to provide an estimation of the likelihood of similar items reoccurring in the future, so that investors and analysts can make more informed decisions.
5. Are significant abnormal gains offsetting abnormal losses?
If a company reports significant abnormal gains that offset abnormal losses, it means that the company has experienced one-time or infrequent events or transactions that have had a positive impact on its financial performance. This can result in a higher reported profit or lower reported loss than would have been the case without the gains.
It’s important to note that while significant abnormal gains can offset abnormal losses, they are not considered to be recurring in nature and therefore, are not a reliable indicator of a company’s ongoing financial performance. Therefore, it’s important for investors and analysts to consider both the abnormal gains and losses when evaluating a company’s financial performance and to look at the underlying reasons for these items.
It’s also important to note that even if the abnormal gains offset the abnormal losses, it’s important to consider the underlying reasons for these items and the likelihood of them reoccurring in the future. This will help investors and analysts to make more informed decisions about the company.
In addition, abnormal gains and losses should be disclosed separately in the financial statements and accompanied with an explanation of their nature, the reason for their occurrence and the estimated impact on the financial statements. This will help investors and analysts to understand the true financial performance of the company and make informed decisions.