While the balance sheet is like a snapshot of a company's financial structure at a specific point in time, the income statement is more like a motion picture showing the firm's operating activities for an entire year.

The balance sheet can show how financially sound a company is. The income statement can answer every investor's central question: "How much money are they making?" Even more important, the income statement can provide a solid basis for forecasting future profits.

Here, more than anywhere, one-year figures are all but worthless in predicting future performance. Since most income statements include three years of information, it's best to download at least two from freeedgar.com or your favorite info source.

For my examples, I imported the 10-Ks from Anheuser-Busch (BUD:NYSE - news) from 1997 and 1994 directly into my Excel spreadsheet to get a full six years of data in an easily handled format.

Overview

Understanding the layout of an income statement is a fairly intuitive process. After starting at the top with "sales" or "gross revenue" (whatever the main source of income is for the firm), the company subtracts out itemized expenses to get to a final net income (or loss) for the year. Think of it like getting your paycheck and then deducting taxes, rent, living expenses and insurance. The amount left over is your discretionary income or profit for the month.

One big difference between you and the firm (other than that they deal in millions rather than thousands) is that the term "income" doesn't necessarily refer to cash in hand. The accrual rules of accounting state that a firm can record income when it sells goods or services regardless of when payment is actually received. In addition, expenses are recorded at the time the purchased asset is actually used.

If, for example, a firm bought a five-year insurance policy at the beginning of 1998 for $10,000, it would record only $2,000 per year as an insurance expense until the policy expires, instead of expensing the entire 10 grand up front.

It's kind of a technical distinction but an important one, since a company with positive earnings on the income statement can still go bankrupt if it doesn't have enough cash on hand to meet day-to-day needs. That's why checking the balance sheet for sufficient working capital through the "current asset" ratio as described in part two is so critical.

EPS Growth

Assuming the firm checks out for reasonable financial soundness (again, see the prior discussion of the balance sheet), turn your attention to the bottom line of the sheet called "earnings per share" to see how the company stacks up over several years of performance. This figure represents the total net income divided by the number of shares the firm has issued. Think of it as your share of the corporation's overall profit if it paid everything out to the stockholders and kept nothing to reinvest in the business.

If the earnings are declining over time or jump around unpredictably, then you may want to bag your analysis and pick another stock. While there may be money to be made trading some of these issues in the short run, the fundamentalist is looking for steady, long-term earnings growth -- even better if it seems to accelerate over time. You might even want to plot the percentage growth on your spreadsheet to get an idea of just how fast the firm is growing.

For BUD, the earnings history seems a little erratic in recent years, especially for a producer of consumer staples like beer. The company even had a bit of a stumble in 1995, so I went back an additional six years to get a longer view. While the earnings picture that emerged seemed pretty stable, sloping higher at around 11% per year, the pace of growth also appears to be tapering off a bit. I'll call the whole thing a yellow flag for now.

Profit Margin

The profit margin is simply the net income divided by the gross revenues (or sales). The resulting figure (see blue line in graph below) shows the percentage of each dollar received that made it to the bottom line as profit for the firm.

In 1997, BUD kept 10.6 cents of every dollar it received as profit. (Because of an excise tax in the income statement, I used net sales in this case. You can also do the calculation excluding one-time charges from net income. That's the green line in the graph.) In and of itself, this profit margin number is pretty much meaningless. Compared to its rival Coors (ACCOB:Nasdaq - news), which sports a scant 3.8% profit margin, however, this profit margin starts to look pretty good.

You can also compare Anheuser's profit margin with the entire brewing industry on services like RapidResearch , which shows BUD sporting margins 40% higher than the industry average.

Even more telling is how margins change over a period of, say, five to six years. Plugging a quick formula into your spreadsheet (net income divided by gross revenues), you see that that BUD has steadily grown its profit margin from around 8.5% in the early '90s.

This means that Anheuser-Busch is making more money on every mug of suds sold to the parched public. Coupled with sales increases ringing in at nearly $13 billion for the year, those pennies really add up. What we don't want to see is a firm with steadily declining margins.

There are two ways a company can grow earnings over time. It can either increase revenues or cut costs. BUD seems to be handling itself well on both fronts and gets high marks for overall profitability.

Interest Coverage Ratio

Few things will panic investors more than a company that's unable to make its interest payments. While (most) stockholders are in for the long run and can weather the occasional bad quarter, bond investors demand their payoff every year like clockwork and are notoriously unforgiving if those checks stop rolling in. The next examination of the income statement is to make sure the firm can meet the demands of its creditors even during a temporary downturn.

The interest coverage ratio takes the earnings before interest and taxes, or EBIT and divides it by the interest expense to figure out how many times over the interest payments could be met with current income. Since EBIT isn't always itemized on the income statement, you need to do some simple figuring.

Think of the process like trying to find out the maximum number of home mortgage payments you could make with your current level of income. The first step is to find your taxable income for the period, which in a corporation's case is titled intuitively enough "pretax income." You might be tempted to just divide this number by your current debt payment to get your "mortgage coverage ratio." But wait!

Since the government allows you to deduct this expense from your taxable income, the pretax income figure already has your current interest payments taken out. Since the question is "how many houses can I afford in total" and not "how many more houses can I afford," you need to add back the current interest expense to your pretax income before doing the final calculation.

For BUD in 1997, the formula looks like this (figures in millions):

$1,832.5 (pretax income) + 261.2 (interest expense)

--------------------------------------------------------------------------------

261.2 (interest expense)

=8.0

In other words, BUD has eight times as much income as it needs to make its required interest payments. Analysts recommend that firms be able to cover their interest charges at least three to four times over, so BUD is in great shape here.

P/E Ratio

Akin to the earnings per share is the price-to-earnings ratio, or P/E. It's calculated simply by dividing the market price of the stock by its current EPS to give an earnings "multiple." The figure is a way of comparing prices of stocks on a relative basis. A $100 stock trading at a P/E of 8 is "cheaper" than a $20 stock with a 30 P/E.

Some folks think that low-P/E stocks are always better then high-P/E issues. Unfortunately, there are no absolutes. High-growth stocks usually deserve a higher multiple than their stodgier brethren because of higher expectations for future performance. Conversely, some value investors would argue that these high-P/E stocks have further to fall if their earnings ultimately disappoint, because those same inflated expectations are fully priced into the stock.

Low P/E stocks seem to offer a type of safety net since the market isn't expecting much from them in the first place. The risk here is that these bottom-feeders might hang around their current trading levels for years and never make a substantial move to the upside.

Our calculation of P/E relies on "trailing" earnings -- the real earnings in the past rather than future expectations. Some analysts like to make an earnings forecast and then quote the stock on a "forward P/E" basis. A stock, for example, with a current multiple of 50 that is expected to double its EPS next year would trade at a forward P/E of only 25. Admittedly, forward P/Es might be a better way to view the whole value proposition, but problems arise in determining whose forecast is reliable enough to use.

That said, using current or trailing P/E to measure relative value is fine. Just keep it in perspective. A stock trading way above its historical multiple or well above the industry P/E and broader S&P multiple had better be up there for a good reason (something like a hot new product, dramatically improved productivity or promising new alliance). Conversely, a stock with a low P/E might not be a screaming bargain if the company is having internal problems.

But assuming the stock clears the other fundamental hurdles as described here, a relatively low-P/E stock compared to its own history or industry average might just be the perfect value you've been waiting for. At the end of '97 BUD was trading at 18.6 times earnings, which was about average for the industry.

Summary

A basic approach to dissecting the income statement might go something like this:

EPS Growth: Earnings that are steadily increasing over time at a respectable rate get passing grades; otherwise, think hard about the long-term prospects of such a firm.

Profit Margin: Steadily increasing profit margins get the thumbs up; declining margins are the sign of a struggling company.

Interest Coverage Ratio: A figure of 3 to 4 is the bare minimum. Anything higher and you're in good shape.

P/E Ratio: No absolutes here. A low one relative to the industry or historical averages is the sign of a good value, assuming other areas check out.
Next in Part 4, we'll put it all together and flesh out the process to answer the central question: Is BUD a buy?