What an Investor Needs to Know about the Income Statement

The Income Statement

The income statement is a very important piece of financial data for investors to measure how well a business performed over a certain period. Usually, the income statement is for a period of 3 months (quarterly earnings) or 1 year (annual earnings). Investors use the income statement to judge how profitable a business is and how its most recent earnings stack up to previous periods. This helps investors determine if the business is growing or shrinking. This post will cover how to read the income statement.

Analyzing The Income Statement

An income statement is broken down into a few key sections these are:
• Revenue
• Cost of Revenue
• Gross Profit
• Operating Expenses
• Operating Income/Loss
• Income from Continuing Operations
• Net Income from Continuing Operations
• Non-recurring Events
• Net Income

To begin analyzing the income statement it’s important an investor knows what each item is and how it affects a business. Just looking at net income could be very misleading. During any one period, business can use several methods to artificially inflate net income. Understanding the income statement will help you determine the sustainability of a business’s profitability. While this may be an extreme case of why it’s important to understand each item on the income statement there are many other reasons why just looking at net income is not a reliable way to measure a business’s profitability. I’ll cover each section in-depth one-by-one.

Revenue Section

Revenue

If you are reading this post you probably already have a good grasp on revenue and what it means. Just in case, revenue is the total amount of money a company receives during a specific period for the sale of its products and/or services. Revenue is the top item on an income statement and is the starting point for calculating the businesses net income. Revenue is calculated by multiplying the price at which goods and/or services are sold by the total number of units or services sold.

Cost of Goods Sold

The direct costs attributable to the production of goods the business sold during the period. This number includes labor, materials and production costs. Costs of goods sold is the cost a business incurs to create the products that it’s selling. This number does not include things such as distribution and marketing costs.
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Gross Profit

Gross profit is the amount of money the company generated after it deducts the costs of goods sold from revenue. This number represents how much money the company is making on the sales of its goods or services. A good way to measure gross profit is to compare the business you are looking at to other businesses in the same industry. This will help investors determine if the company is more/less efficient then its competitors. It is very important to only measure this number against competitors that are producing similar products or sell similar services. Since Gross profit margin varies greatly from industry to industry it’s impossible to say what a good percentage is. to calculate gross profit margin simply divide gross profit from revenue.

Operating Expenses

Operating expenses are the costs a company incurs in order to sells its good or services. This includes things such as shipping, marketing, and selling costs. Under the operating expenses you will typically find the following items:
• Research and Development
• Selling and Administrative
• Non-recurring

Research and Development

Research and development costs is the money a business uses to to invest in new advances in their products or services. For highly technical companies this is a very important part of a business to stay in the lead, but for a cigarette company R&D will be relatively low. By looking in the notes on a financial statement (or company press releases and keynotes) investors can see what the company is developing.

Selling & Administrative

These are the costs a company pays to sell their products (advertising & marketing), and the money they pay to its executives. This is a pretty important number to look at for investors. If you look in the notes of a financial statement you can see what they pay to their executives. You can also look to see how much money they used to sell their products. An investor can measure how much success they believe a company will have by understanding ROI from their marketing and advertising budgets.

Non-recurring

Non-recurring expenses are a one time expense that is unlikely to happen again. This could be an inventory write-off or many other things. Its important to check the company’s notes to understand this cost and if it could adversely affect the business.

Income from Continuing Operations

• Other Income/Expenses
• Earnings before Interest and Taxes
• Interest Expense
• Income Tax Expense
• Minority Interest

Other Income/Expenses

Other Income/Expenses are items the company made or lost money on that are not tied in directly to their core business model. It could be income or losses from other investments the business had made. Again, it’s important to check the company’s notes to see the details behind this gain or loss.

Earnings Before Interest and Taxes

Earnings before interest and taxes (EBIT) is a very important number for investors to look at. This is the amount of money the company generated before its tax and interest expenses. EBIT is also referred to as operating profit or earnings. It is used as a measure of profitability of a company.

Interest Expense

The interest expense is how much money a company has to pay to cover the interest on the debt it owes. When looking at interest expense you want to see how many times over a company can cover its interest payments. a company that has a low ratio has not effectively leveraged its earnings from the debt it acquired.

Income Tax Expense

This is the money a company owes to the government. Every for profit business has to pay its taxes. A few things to look at for taxes are net loss carryovers and deferred taxes. You want to see if a business has deferred its taxes to a later date or if it is able to carry over a previous loss to its current profitability. While this expense is not often looked at it can be an important number for investors.

Minority Interest

Minority interest is a businesses interest in another company or subsidiary. A company must own a controlling interest (greater than 50% and less than 100%) in another business. Since the subsidiary is mostly owned by the parent company it will consolidate the earnings statements and mark down the rest of the profit as an expense to give the minority interest holder its share of the profits.

Non-recurring Events

• Discontinued Operations
• Extraordinary Items
• Effect of Accounting Change

Non-recurring events could be lines of business the company no longer wishes to pursue or it could be the effect of changing its accounting system. These items are very rare for a company and will not be posted on their income statement every period. Since these charges are only one time events its is important to check the company’s notes in their financial statement to understand them thoroughly.

Net Income

Net income is the most looked at part of a company’s income statement. Net income is the amount of money the company generated after it subtracts all its expenses from revenue. To fully understand how a company made its money its important to understand all the items on a financial sheet. Sometimes you can see extraordinary gains/losses that could make net income seem much higher or lower than it normally would be. This can throw off an investors and make them falsely believe the company grew more than it actually did. To learn more about net income and how that actually turns into cash read my piece on the statement of cash flows.

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