Show Me the Money: All you need to know to understand an income statement

By Nancy Zambell, Contributing Editor

The Income Statement, also called the Profit and Loss Statement (P&L), shows investors whether a company made or lost money during the reporting period—usually three or 12 months. It accounts for all revenues received (the top line), then deducts all expenses, resulting in net income (the bottom line). Results of the two years prior are also included for comparative purposes.  

This important statement is a tool to aid investors and creditors in assessing the past performance of a company, its future potential, and also help in determining the company’s risk and probability of generating cash flows into the future. 

There are two types of income statements:  

The single-step statement is simple; expenses are deducted from revenues to get net income.  

However, most companies use the multi-step income statement, which performs several subtractions to calculate the bottom-line net income. This results in four measures of profitability—gross, operating, pretax and after tax.  

These are the major accounts found on the Income Statement:  

Net Sales includes revenues net of returns, breakage allowances, freight-out and discounts.

Cost of Goods Sold reflects the cost of buying raw materials and producing finished goods.

Gross Profit is simply net sales minus the cost of goods sold, or the revenues after accounting for the cost to make a product or provide a service. This measure deducts only the variable costs traceable to actually producing the product, not indirect expenses such as salaries, rent, etc.

Depreciation is a noncash expense, an amortization of fixed assets, to allocate their cost over their depreciable life.

Selling, General and Administrative Expenses are all expenses associated with the normal operations of the business that were not included in cost of       goods sold. Examples are salaries, rent, utilities and advertising.

Research & Development (R&D) expenses represent costs that are critical in industries such as biotech or computer technology. Growth or reductions in R&D can be a telling sign of the company’s future intent.               

Net Operating Profit is what is left over after deducting cost of goods sold, depreciation and SG&A expenses from net sales; it tells you the company's profit on an operating basis without taking into account any unusual items of income or expense or interest and taxes.

Other Income or Expenses are any unusual income or expense items that are reported separately so that analysts can get a better picture of future cash flows based on normal, recurring income or expense items, without taking into consideration items that may not recur in the next reporting period. Other income may include gains or losses from investments or the sale of fixed assets. Other expenses may include costs from discontinued operations, expenses from regulatory changes, or restructuring charges.

Interest expense is sometimes included in this category.

Earnings Before Income Taxes nets out all pretax income and expense items and is the favored comparative measure for most analysts, since it excludes any extraordinary items like monies set aside for severance packages, the results of discontinued operations, expenses due to regulatory changes, etc.

Provision for Income Taxes is the company's tax liability for the period in question.

Net Income equals the bottom line—how much the company has earned—after netting out all expenses except for dividends.

Earnings per Share is net income divided by the weighted average of shares outstanding. There are two forms of EPS reported:

Basic includes only actual shares outstanding.

Diluted is calculated as if all stock options, convertible bonds and other securities that   could be transformed into shares have become actual shares. This results in an increase in the number of shares outstanding and a decrease in EPS. Analysts prefer to use diluted EPS as a more accurate measure of a firm’s profitability. 

Limitations  

It is important that investors be aware that the information in an income statement does have several limitations: 

Brand recognition, loyalty and goodwill – Characteristics that might be relevant and important but cannot be reliably quantified, so they are not reported

Alternate accounting methods (e.g., using FIFO or LIFO) used to measure inventory will impact expense and income accounts. For example, FIFO, or First-In, First-Out, will most often result in lower cost of goods sold (and higher profit) as the merchandise being accounted for is from older inventory, and therefore, probably cost the company less than its newer merchandise. The LIFO, or Last-In, Last-Out method would have the opposite effect. Additionally, different depreciation methods will also change the numbers on an income statement.

Accounts dependent on estimates, such as depreciation expense, will affect the numbers on the income statement. These costs are calculated, based on estimated useful life and salvage value, which may differ, depending on who’s doing the accounting! 

How to Decipher what the Income Statement is Telling You 

You will need to perform a series of calculations in order to understand if the relationship between a company’s income and expenses is healthy. The most important of these is calculating “percentage of sales”—simply dividing each account by sales and then determining if the item has increased or decreased relative to sales over a period of time.  

If the account substantially changed, the next step is attempting to determine the reasons for the change and deciding if the growth or reduction is acceptable to you. Be on the lookout for significant growth or decreases in particular accounts, especially expense accounts such as interest. Increased interest expenses may reflect the company taking on extra debt. That’s not necessarily a bad thing, as long as they are using the debt to generate extra income to the company’s bottom line. 

You will also want to determine if income is growing because of increased sales, lowered expenses (including taxes), or both. Income and revenue should both be growing in tandem. That doesn’t necessarily mean that each has to be advancing at the same rate. But if revenues are growing exponentially, for example, and net income is not, you need to ask yourself, why? There could be a couple of good reasons for it; the company may be new, and it’s pretty difficult to make a profit right away with a new business. Or, the company may have entered a new line of business or expanded geographically, which entails added expenses. However, it could also just mean that the company is not exercising good cost controls. 

The income statement will give you a really good picture of what is going on at a company. And it is imperative that you familiarize yourself with it, comparing it to the company’s previous statements so that you can determine if the company is managing its revenues and expenses efficiently to generate growing profits. That, after all, is the key to stock appreciation in the long-run. If a company doesn’t have a future of increasing earnings, why would you want to buy its shares? 

So, take out your pencil and calculator and delve into the income statements of your investments. Trust me, it won’t be time wasted!

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

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