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Understanding The Income Statement

2011-07-29 09:10:16

The income statement is one of the three financial statements - the other two

are the balance sheet and cash flow statement - with which stock investors need

to become familiar. The purpose of this article is to provide the

less-experienced investor with an understanding of the components of the income

statement in order to simplify investment analysis and make it easier to apply

it to your own investment decisions.

In the context of corporate financial reporting, the income statement

summarizes a company's revenues (sales) and expenses quarterly and annually for

its fiscal year. The final net figure, as well as various others in this

statement, are of major interest to the investment community. (To learn more

about reading financial statements, see What You Need To Know About Financial

Statements, Footnotes: Start Reading The Fine Print and Introduction To

Fundamental Analysis.)

General Terminology and Format Clarifications

Income statements come with various monikers. The most commonly used are

"statement of income," "statement of earnings," "statement of operations" and

"statement of operating results." Many professionals still use the term "P&L,"

which stands for profit and loss statement, but this term is seldom found in

print these days. In addition, the terms "profits," "earnings" and "income" all

mean the same thing and are used interchangeably.

Two basic formats for the income statement are used in financial reporting

presentations - the multi-step and the single-step. These are illustrated below

in two simplistic examples:

Multi-Step Format Single-Step Format

Net Sales Net Sales

Cost of Sales Materials and Production

Gross Income* Marketing and Administrative

Selling, General and Administrative Expenses (SG&A) Research and Development

Expenses (R&D)

Operating Income* Other Income & Expenses

Other Income & Expenses Pretax Income

Pretax Income* Taxes

Taxes Net Income

Net Income (after tax)* --

In the multi-step income statement, four measures of profitability (*) are

revealed at four critical junctions in a company's operations - gross,

operating, pretax and after tax. In the single-step presentation, the gross and

operating income figures are not stated; nevertheless, they can be calculated

from the data provided.

Tutorials: An Introduction To Fundamental Analysis

In the single-step method, sales minus materials and production equal gross

income. And, by subtracting marketing and administrative and R&D expenses from

gross income, we get the operating income figure. If you are a

do-it-yourselfer, you'll have to do the math; however, if you use investment

research data, the number crunching is done for you.

One last general observation: Investors must remind themselves that the income

statement recognizes revenues when they are realized (i.e., when goods are

shipped, services rendered and expenses incurred). With accrual accounting, the

flow of accounting events through the income statement doesn't necessarily

coincide with the actual receipt and disbursement of cash. The income statement

measures profitability, not cash flow. (To find out more about cash flow, see

What Is A Cash Flow Statement?, The Essentials Of Cash Flow and How Some

Companies Abuse Cash Flow.)

Income Statement Accounts (Multi-Step Format)

Net Sales (a.k.a. sales or revenue): These all refer to the value of a

company's sales of goods and services to its customers. Even though a company's

"bottom line" (its net income) gets most of the attention from investors, the

"top line" is where the revenue or income process begins. Also, in the long

run, profit margins on a company"s existing products tend to eventually reach a

maximum that is difficult on which to improve. Thus, companies typically can

grow no faster than their revenues.

Cost of Sales (a.k.a. cost of goods (or products) sold (COGS), and cost of

services): For a manufacturer, cost of sales is the expense incurred for raw

materials, labor and manufacturing overhead used in the production of its

goods. While it may be stated separately, depreciation expense belongs in the

cost of sales. For wholesalers and retailers, the cost of sales is essentially

the purchase cost of merchandise used for resale. For service-related

businesses, cost of sales represents the cost of services rendered or cost of

revenues. (To learn more about sales, read Measuring Company Efficiency,

Inventory Valuation For Investors: FIFO And LIFO and Great Expectations:

Forecasting Sales Growth.)

Gross Profit (a.k.a. gross income or gross margin): A company's gross profit

does more than simply represent the difference between net sales and the cost

of sales. Gross profit provides the resources to cover all of the company's

other expenses. Obviously, the greater and more stable a company's gross

margin, the greater potential there is for positive bottom line (net income)

results.

Selling, General and Administrative Expenses: Often referred to as SG&A, this

account comprises a company's operational expenses. Financial analysts

generally assume that management exercises a great deal of control over this

expense category. The trend of SG&A expenses, as a percentage of sales, is

watched closely to detect signs, both positive and negative, of managerial

efficiency.

Operating Income: Deducting SG&A from a company's gross profit produces

operating income. This figure represents a company's earnings from its normal

operations before any so-called non-operating income and/or costs such as

interest expense, taxes and special items. Income at the operating level, which

is viewed as more reliable, is often used by financial analysts rather than net

income as a measure of profitability.

Interest Expense: This item reflects the costs of a company's borrowings.

Sometimes companies record a net figure here for interest expense and interest

income from invested funds.

Pretax Income: Another carefully watched indicator of profitability, earnings

garnered before the income tax expense is an important step in the income

statement. Numerous and diverse techniques are available to companies to avoid

and/or minimize taxes that affect their reported income. Because these actions

are not part of a company's business operations, analysts may choose to use

pretax income as a more accurate measure of corporate profitability.

Income Taxes: As stated, the income tax amount has not actually been paid - it

is an estimate, or an account that has been created to cover what a company

expects to pay.

Special Items or Extraordinary Expenses: A variety of events can occasion

charges against income. They are commonly identified as restructuring charges,

unusual or nonrecurring items and discontinued operations. These write-offs are

supposed to be one-time events. Investors need to take these special items into

account when making inter-annual profit comparisons because they can distort

evaluations.

Net Income (a.k.a. net profit or net earnings): This is the bottom line, which

is the most commonly used indicator of a company's profitability. Of course, if

expenses exceed income, this account caption will read as a net loss. After the

payment of preferred dividends, if any, net income becomes part of a company's

equity position as retained earnings. Supplemental data is also presented for

net income on the basis of shares outstanding (basic) and the potential

conversion of stock options, warrants etc. (diluted). (To read more, see

Evaluating Retained Earnings: What Gets Kept Counts and Everything You Need To

Know About Earnings.)

Comprehensive Income: The concept of comprehensive income, which is relatively

new (1998), takes into consideration the effect of such items as foreign

currency translations adjustments, minimum pension liability adjustments and

unrealized gains/losses on certain investments in debt and equity. The

investment community continues to focus on the net income figure. The

aforementioned adjustment items all relate to volatile market and/or economic

events that are out of the control of a company's management. Their impact is

real when they occur, but they tend to even out over an extended period of

time.

Sample Income Statement

Now let's take a look at a sample income statement for company XYZ for FY

ending 2008 and 2009 (expenses are in parentheses):

Income Statement For Company XYZ FY 2008 and 2009

(Figures USD) 2008 2009

Net Sales 1,500,000 2,000,000

Cost of Sales (350,000) (375,000)

Gross Income 1,150,000 1,625,000

Operating Expenses (SG&A) (235,000) (260,000)

Operating Income 915,000 1,365,000

Other Income (Expense) 40,000 60,000

Extraordinary Gain (Loss) - (15,000)

Interest Expense (50,000) (50,000)

Net Profit Before Taxes (Pretax Income) 905,000 1,360,000

Taxes (300,000) (475,000)

Net Income 605,000 885,000

Now that we understand the anatomy of an income statement, we can deduce from

the above example that between the years 2008 and 2009, Company XYZ managed to

increase sales by about 33%, while reducing its cost of sales from 23% to 19%

of sales. Consequently, gross income in 2009 increased significantly, which is

a huge plus for the company's profitability. Also, general operating expenses

have been kept under strict control, increasing by a modest $25,000. In 2008,

the company's operating expenses represented 15.7% of sales, while in 2009 they

amounted to only 13%. This is highly favorable in view of the large sales

increase.

As a result, the bottom line - net income - for the company in 2009 has

increased from $605,000 in 2008 to $885,000 in 2009. The positive inter-annual

trends in all the income statement components, both income and expense, have

lifted the company's profit margins (net income/net sales) from 40% to 44% -

again, highly favorable.

Conclusion

When an investor understands the income and expense components of the income

statement, he or she can appreciate what makes a company profitable. In the

case of Company XYZ, it experienced a major increase in sales for the period

reviewed and was also able to control the expense side of its business. That's

a sign of very efficient management.

For more insight, see Find Investment Quality In The Income Statement and

Advanced Financial Statement Analysis.

by Richard Loth

Richard Loth has more than three decades of international experience in banking

(Citibank, Industrial National Bank, and Bank of Montreal), corporate financial

consulting, and non-profit development assistance programs. During the past 12

years, he has been a registered investment adviser and a published author of

books and publications on investing. Currently, he devotes his professional

activities to educational endeavors, writing and lecturing, aimed at helping

individual investors improve their investing know-how (see http://