Appendix A: Market Research
Income Statement Analysis
The two corporate financial statements that contain most of the information used in this investigation are the Income Statement and Balance Sheet. Data is publicly available unless stated otherwise.
The Income Statement reports period sales and expenses and calculates whether profits have been earned. Profits are essential, for if the company is not profitable, it is not generating new capital. Growth requires additional capital and, if the company is not generating the needed capital, it either has to raise more capital by selling stock (or potentially borrowing money) or deplete its existing capital. Once expenses cannot be covered by either profits or capital, the company is insolvent.
Revenue Less Expenses = Profit or Loss
Revenue: Revenue is usually recognized when product is shipped or service has been performed. Revenue that has been recognized, but for which payment has not been received, is classified as Accounts Receivable (See Balance Sheet).
Expenses: All period expenses for this investigation will be defined as follows: Costs and expenses are synonymous. All expenses other than Direct Costs are often called Overhead and, in this convention, would be the sum of Technological Innovation, Buying Demand and Organization expenses.
Direct Costs: All expenses that are directly related to product shipped or services performed. Material costs, direct labor, allocated production overhead and shipping costs are the major Direct Cost categories.
Technological Innovation: Usually labeled Engineering or Research and Development, Technological Innovation expenses represent those period costs associated with innovating new and improving existing products. Companies often amortize some development costs over the life of the product rather than report costs as incurred.
Buying Demand: All Sales and Marketing expenses. Unfortunately, over time accounting conventions have changed and some Buying Demand costs have been combined with Organization expenses. Likewise, commissions paid on sales are often reported as Direct Costs rather than as Overhead.
Organization: Normally referred to as General Expenses, Organization costs are those not directly tied to either innovating or selling product. Executive management, accounting, finance and facilities expenses constitute the bulk of Organization expenses. Interest expense, or income, is usually reported as a separate line item.
Profit or Loss: Generally called Net Income, and is Revenue less all expenses. Most companies report both an Operating Income as well as Net Income. Operating Income is Revenue less all Expenses other than Interest and Extraordinary expenses, where Extraordinary are one-time write-offs due to corporate re-organizations or changes in business practice.
Gross Margin = Revenue Less Direct Costs. Gross Margin is a very important indicator of the value of a company’s product as well as the pricing freedom a company has. The higher the Gross Margin the more value provided and freedom in pricing. As a general rule, companies that sell systems direct to end user customers will have a Gross Margin of 65% or more whereas companies that sell product through distribution have difficulty maintaining a Gross Margin of 50%.
The Cycle of Investment and Profits: When a company first starts out, its challenge is to innovate product. Having no sales, it raises risk, or venture, capital, to fund product development and begin building its distribution system. This start-up stage generally lasts from one to two years. Once the company begins to sell and service product, additional financing is required to fund organization ramp-up, including the acquisition of Fixed Assets and Inventory and financing of Accounts Receivable (See Balance Sheet). If the company is successful, by its third or fourth year, it will be generating profits that finance continued company growth and eventually earn a return for those equity - venture capital - investors who supported the company in its earlier years.
The Initial Public Offering (IPO): For the successful company, the ideal way to raise both inexpensive capital to fund growth as well as provide a mechanism for investors to realize a return without forcing the company to distribute Net Income, is to sell shares of stock in a public offering. Once a company is public, all investors, subject to certain rules of course, can sell and buy stock without the company having to do anything other than comply with disclosure and reporting requirements. If the demand for the company’s shares of stock is strong, the price per share will go up. If so, the company can benefit by selling more shares and raise even more capital at a lower price.