What is the Income Statement?
The income statement is one of four financial statements (income statement, retained earnings statement, balance sheet, cash flow statement) reported every quarter and year by a publicly traded company.
The purpose of the income statement is to detail the sales, expenses, taxes paid, and the resulting net income.
The first item, also called top line item, of the income statement is the revenue. It is the sum of all sales recorded during a reporting period.
Cost of Goods Sold (COGS)
The second line of the income statement is cost of goods sold (COGS), also called cost of revenue. It is production expense account, listing the cost of materials and labor used to produce goods and services.
Law requires companies to disclose the way COGS is calculated, and this is something that should be investigated by investors like us (by reading the annual reports), as this gives insight into management’s way of thinking about reporting expenses.
The company’s gross profit is calculated by subtracting the COGS from the revenue. From gross profit, we can calculate the gross profit margin (= gross profit/revenue), a useful metric to assess a company’s cost management.
The next section includes various expenses categorized as operating expenses, including selling, general and administrative (SG&A), research and development (R&D), depreciation and amortization, and other operating expenses.
Selling, General & Administrative (SG&A)
Selling expenses include any advertising costs, labor costs that are not attributed to creating the products/offering services (part of COGS), rent and taxes related to selling. General expenses are expenses related to operating the company. Administrative expenses include executive salaries, general administrative support and taxes related to administration of the business.
Research & Development (R&D)
Continuous R&D is necessary for most businesses to innovate and stay competitive, introduce new products and services, and break into new market segments. The percentage of sales spent on R&D ranges from low (e.g. stable companies) to high (e.g. technology-heavy, pharmaceutical companies).
A firm with a durable competitive advantage and low R&D costs is much more favorable for investors than a R&D heavy company since the money saved can be invested in ways that will benefit the shareholders and the long term growth of the company.
Depreciation & Amortization
Depreciation & amortization are asset write-offs over the assets’ useful life times. Depreciation is for tangible, fixed assets (e.g. a fleet of trucks), and amortization for intangible assets (e.g. patents, trademarks, goodwill).
Other Operating Expenses
Other operating expenses include any operating expenses that don’t fall in one of the categories mentioned above, and could include expenses such as operating leases or IT.
Operating Profit (= EBIT)
After subtracting all operating expenses from the gross profit, we end up with the operating profit, also called earnings before interest and taxes, EBIT. Operating profit shows us how much money is left over before interest and taxes have to be paid. It allows us to get a quick view at the percentage of operating profit to interest payments (i.e. the company’s debt obligations), an indicator of the company’s financial strength on a continuing basis.
Interest expense is a financial expense. It reflects the interest amount paid during the quarter or year on the debt carried on the balance sheet.
In general, a low ratio of interest expense to operating profit is preferred. It tells us that the company does not carry excessive amounts of debt, which, as the 2008 financial crisis showed, can become disastrous for companies.
Companies with a low ratio of interest expense to operating profit are more likely to be the ones with a durable competitive advantage. However, this ratio varies greatly from industry to industry, and when assessing a company, the interest expense/operating profit ratio should be compared to competitors in the same industry.
Gain (or Loss) on Sale of Assets
The line gain (loss) sale assets records the profit or loss from a company selling an asset (other than inventory).
Let’s assume a company is selling a machine that it originally paid $1,000,000 for, and at the point of the sale, the machine is still worth $400,000 according to the balance sheet. If the company sells the machine for $500,000, it would record the difference of $100,000 as a gain on the income statement. Alternatively, if the company sold the machine for only $300,000, it would record a loss of $100,000 on the income statement.
A sale of an asset is a non-recurring event and should therefore be removed from the calculation of net earnings when trying to figure out whether a company has a competitive advantage.
Next, the line other sums up any non-recurring, non-operating items such as the sale of fixed assets like property, plant and equipment. Another example would be the sale of a patent.
Income Taxes Paid
As the name income taxes paid suggests, this line lists the company’s income tax amount for the quarter or year.
Net earnings, also called net income, is the very last line on the income statement, and it reflects the amount of revenue left over after subtracting all expenses and income tax.
Since it is the last line of the income statement, net earnings is also referred to as the bottom line.
Net earnings, expressed as earnings per share (EPS), is the main number Wall Street analysts are focussed on when companies report their financial results. This is because the earnings and share price performance show a strong correlation over the long term.
Net earnings is also an important number for us to figure out if a company is worth investing in by looking at the earnings themselves, and by calculating and evaluating the ratio of net earnings to revenue (also called net margin).
Why is the Income Statement Important for us as Investors?
The income statement contains important numbers that allow us to make inferences about whether a company has a competitive advantage or not. It also contains crucial information that we need to value a company, i.e. determine its intrinsic value.