That’s where deceptive part of description comes in. The items on income statement are easily manipulated by, say, less-than-honest management, and don’t necessarily represent true situation at a company. Even totally honest companies can have income statements that don’t represent economic reality. Cash flows define economic reality, revenue and expenses define accounting reality.

You see, difference between your household budget and a company’s income statement is their relationships to actual cash flows. Your household budget will generally match your cash inflows and outflows. Not so with an income statement. Income statements can vary significantly from company’s cash flow, meaning that a company in economic trouble can show a very “good” income statement up until day it goes bankrupt.

Generally speaking, though, income statement is a good place to start when evaluating a company. In my forthcoming e-book, Fundamentals of Financial Statement Analysis, I lay out process for evaluating health of a company through financial statements. I’m shooting for publication in beginning of 2004, but in meantime, here are some tips and strategies for evaluating an income statement.

1. Create a Common Size Statement

What’s a common size statement, you ask? It’s income statement, only with each line item represented as a percentage of sales. This is easy to do with a spreadsheet on your computer, but you can do it on paper just as well. Net Sales is always 100% at top, and each of expenses is divided by total sales to arrive at a percentage. For example, if a company has $100 in sales and $50 in cost of goods sold, common size statement will look like this:

Sales 100% Cost of Goods Sold 50% Gross Profit 50%

The importance of common size statement can’t be overstated. It gives you calculation of all your profit margins, from gross to net, and shows how much each cost item takes away from your profits.

2. Create a Year-to-Year Comparison Statement

The next step is to make a year-to-year comparison statement. You can’t evaluate financial statements for just a single year; they have to be compared to previous years. The only formula you need to know for these calculations is:

(current year / previous year) – 1 = % change

Again, a spreadsheet makes this process so much easier, but it can be done by hand. I like to have five years of data, which yields four years of comparison data. This way you aren’t just looking at an exceptionally good or bad year for analysis. Plus, you can get a reasonable estimate of future growth when you do your discounted cash flow analysis. (I’ll have more on Discounted Cash Flow in future.)

3. Read Management Discussion and Analysis

The National poll was conducted last month to determine how many homeowners take advantage of prepayment loophole in our mortgage system, which eliminates costly interest overpayments.

The shocking results showed only 3% of America’s homeowner population utilize this loophole and take advantage of valuable benefits created by it.

When Sean Drover, a Chicago businessman and homeowner found out he was overpaying $217 in mortgage interest every month, he was appalled. “Honestly, I was sick to my stomach when I thought back on all monthly payments I’d made. If I would have known about pre-payment loophole when I first bought my home I could have put all that money into equity instead of my lenders pocket.”

The problem lies with what banking industry calls “front loading”. This is when majority of a homeowner’s payment is applied towards interest on loan instead of original amount borrowed.

The disturbing fact about front loading is it ensures you’ll pay over three times original amount borrowed. Thus, resulting in enormous profits coming straight out of your pocket and directly into your lenders.