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An income statement is a financial statement used by a company to report financial performance over a specific period of time. It is one of the three major financial statements, with the other two being the balance sheet and statement of cash flows.
The income statement is referred to by many other names including:
- Profit and loss statement, P&L, statement of income, statement of revenue and expense, statement of operations, statement of operating results, statement of earnings
The income statement primarily focuses on a company’s revenues, expenses, gains and losses over a period of time to show a profit or loss. The profit or loss is referred to as “net income,” “profits,” “earnings,” and “income.”
Net income is calculated by taking all revenues and subtracting all expenses.
The simplest formula to represent the income statement would be…
Revenues – Expenses = Net Income
WHAT IS AN INCOME STATEMENT USED FOR?
From the perspective of a company, the purpose of an income statement is to report financial details on the business to its stakeholders, including management, government agencies such as the SEC, and the community of investors and creditors.
The Securities and Exchange Commission (SEC) requires companies to publish income statements at least quarterly and annually.
Management within a company looks at its own income statements to evaluate the company and make decisions. Income statements can be created and dissected in different ways.
- One income statement for the entire company
- Individual income statements for separate business segments
- Income statements for different periods of time (daily, monthly, quarterly, semi-annually, annually)
Management can use the income statement for diagnostics on the company’s strengths and weaknesses in performance. Here are things management will do with income statements:
- Look at where revenues are strong or weak
- Look at where expenses are high or low
- Assess capabilities of generating future cash flows
- Decide to expand or cut out a segment of the business
- Decide to increase production
- Decide to expand into new geographies
- Decide to purchase or sell new assets
From the perspective of the investment community, you would use the income statement to analyze a company’s profitability and growth prospects to make an investment decision or to compare one company’s income statement to another’s.
Creditors will look at an income statement to get an idea on a company’s ability to generate cash flow to make its debt payments.
INCOME STATEMENT STRUCTURE
The two basic formats of the income statements used in financial reporting are the single-step and multi-step income statements.
Single-Step Income Statement
A single-step income statement combines operating and non-operating income and expenses for one simpler calculation.
Formula: (Revenues + Gains) – (Expenses + Losses) = Net Income
Single-step income statements are simple and easy to prepare, however they provide less detail to the user of the statement.
They are generally used by smaller and less complex businesses.
Multi-Step Income Statement
The multi-step income statement is the counterpart to the single-step and takes multiple steps to get to the bottom line.
It separates revenues and expenses into operating and non-operating items.
Cost of goods sold is subtracted from revenues to arrive at gross profit .
Then operating expenses are subtracted from gross profit to calculate operating income.
From here, non-operating revenues and expenses are summed to arrive at net income.
Operating revenues and expenses come from areas of the business that directly relate to its operations.
- Examples include revenues generated through the sales of your goods and services and expenses such as cost of goods sold, research and development, and selling, general and administrative expenses
Non-operating revenues and expenses come from parts of the business that do not relate to its direct operations.
- Examples include interest, gains and losses on asset sales, and other one-time revenues or expenses.
Most companies report their income statement in the multi-step format.
WALK-THROUGH OF MAIN INCOME STATEMENT LINE ITEMS
- Revenue, or sales, is the first line item on the income statement and represents the company’s revenue earned from sales of goods and services.
Cost of goods sold (COGS)
- The cost of goods sold line item represents the direct costs associated with the selling of a company’s goods and services.
- Examples include direct labor and materials
- It excludes indirect costs such as marketing
- Gross profit shows profitability after accounting for direct costs, but before subtracting overhead costs.
- Formula: Gross Profit = Revenues – COGS
Marketing, advertising, and promotion expenses
- These expenses are related to the selling of goods and services through marketing and advertising related activities
General and administrative (G&A) expenses
- G&A expenses represent operational expenses associated with running the business including salaries and wages, rent, utilities, office expenses, travel, insurance.
Research and development (R&D) expenses
- These are expenses incurred through the research and development of new products and services.
- Innovative industries such as technology, health care, and renewable energy tend to have high R&D expenses.
- EBITDA is a measure of standing for “Earnings Before Interest Taxes, Depreciation and Amortization.”
- Companies may or may not report EBITDA on their income statements, but it is an important measure used because it strips out the effects of capital structure, leverage, and non-cash items like depreciation and amortization. This allows for the metric to be more of an “apples-to-apples” comparison to other companies.
- Formula: EBITDA = Operating income + Depreciation + Amortization
- Formula: EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Depreciation & Amortization expense
- Depreciation and amortization are non-cash expenses used to allocate the costs of fixed assets and intangible assets that are capitalized on the balance sheet.
- The expenses are allocated over the lifespan of an asset
Operating income (or EBIT)
- Operating income is the amount earned by a company through regular business operations.
- Because of this, it is popularly looked at to analyze the health of a business’s operations.
- Formula: Operating Income = Gross Profit – Operating Expenses
- Interest is the net amount of interest paid to debt liabilities and interest earned from cash assets
- Other expenses is a catch-all line item for unique expenses to the company or industry that don’t fall within the other expense line items
EBT (pre-tax income)
- Pre-tax income is simply the profitability before taxes are paid
- Total amount of taxes paid by the company
- The net income, commonly referred to as the “bottom-line” because it is literally the bottom line, represents the company’s profit.
- Formula: Net Income = Total Revenue – Total Expenses
- Formula: Net Income = Operating Income + Non-Operating items
Earnings Per Share (EPS)
- Earnings per share is an important metric usually listed below net income on a company’s income statement. It represents the profit amount per share of the company.
- Formula: EPS = Net Income / Shares outstanding
HOW TO ANALYZE AN INCOME STATEMENT
Look at sources of revenue
- Where is revenue coming in from?
- Is it from their core business segments or other segments?
- Is this good news or bad news?
Look at the categories of expenses
- Same tips as above
Analyze the amounts for revenues and expenses
- Is there anything that stands out in the revenue and expense numbers?
- What story does this tell about the business’s health and performance?
Compare and analyze year-over-year numbers
- Comparing year-over-year numbers can help with identifying trends
- Look for abnormal gains or declines and try to find the cause of it.
- Is the cause a one-time occurrence or is the cause from a change in the business?
Connect numbers together
- Connect numbers together to get a picture of what’s going on in the business
- For example, if revenues remained the same, but expenses shot up, something could be wrong with the company’s operations
Use financial ratios and compare year-over-year and to similar companies in the industry
- Financial ratios are a great help to understand a business’s financials
- There are ratios for profitability, leverage, leverage, liquidity, and more.
- You can use financial ratios to compare with other companies or the industry average
- See where a company falls below or above the average and dissect the elements of the ratio to understand why
- Vertical analysis is when you express each line item on the income statement as a percentage of revenues.
- For example, revenues would be 100% of revenues as expected. Gross profit may be 60% of revenues. Net income may be 25% of revenues.
- This analysis allows you to see the proportion that an item makes up of the revenue amount.
- When you run a vertical analysis for year-over-year, you can see if line items are increasing or decreasing its proportion to revenue.
Read management commentary and footnotes
- Management commentary and footnotes can be found in a company’s annual report and quarterly filings.
- In the management commentary section, management will talk about the operations of the business, fresh news and development, and any trends they are seeing.
- In the footnotes, you can learn a lot about the accounting methods used to calculate certain line items and important one-time events can be disclosed in the footnotes.
- Both management commentary and footnotes are insightful to read and can help give you some color around analyzing the income statement.
WHERE TO FIND INCOME STATEMENTS FOR COMPANIES
There are several places where you can find a company’s income statements and other financial statements as well:
- EDGAR stands for Electronic Data Gathering, Analysis, and Retrieval and it is a tool on the SEC website where you can find the filings of companies
- The link is here
Investor Relations Website
- On a company’s website, they will typically have an investor relations website with a bunch of information on the website they want their investors to know about, including financial statement filings.
- Here is a link to Hilton’s (HLT) Investor Relations website as an example
Sites like Yahoo! Finance
- Financial news websites like Yahoo! Finance will have interactive financial statements for public companies on their site. Simply search the company name or ticker in the search bar.
- As an example, here is a link to Tesla’s (TSLA) income statement
- A Bloomberg Terminal is a computer software program that contains a massive amount of financial data on companies
- It is an extremely expensive subscription to have, but if you have access to one, you can find the SEC filings of a company on it
LIMITATIONS OF INCOME STATEMENTS
Doesn’t tell the entire story for a company
- The income statement is just one statement of the three main statements to analyze a company. You shouldn’t come to a conclusion without first analyzing all three together.
- The three statements are linked together, with each containing important information for the overall picture.
Room for manipulation of items
- Through legal, but creative accounting, numbers on the income statement can be adjusted. Income is reported through accrual accounting rule.
Inaccurate estimations and assumptions
- The income statement includes items that have to be estimated and can’t be reliably measured. For example, when a company purchases a capital asset, the estimate depreciation amounts and useful life of assets.
- These estimates can be inaccurate, but will not be reflected on the income statement.
- Companies will also have estimates for number of returns of products for example. The actual number or returns can be far lower or higher than assumed
Differences in accounting methods between companies and industries
- Different industries and different companies within the same industries can have different accounting methods. Before comparing one income statement to another, you should understand the accounting methods of each company you are comparing.
- This will take more work on your end, but looking at management commentary and the footnotes of a company’s financial statements can help you with this
Net income is not deemed as important as cash
- The amount you see for net income can be a different amount based on accounting methods and decisions from a company. Income does not represent cash exchanging hands.
- Cash is a number that is not adjusted. Either the company has a cash amount or it doesn’t. Because of this, the investment community puts more emphasis on cash flow than net income amount