The Income Statement

The Importance of Understanding and Interpreting the Income Statement

The income statement is one of the financial statements that can be found in the company annual 10-­K and quarterly 10­-Q filings. It provides investors with information on a company’s revenues, expenses and profit over a period of time.

Income statement analysis will help you determine how well a company is performing. As a shareholder you want a company to have high profits, which are usually generated when they have low expenses relative to their revenues and their competitors.

Let’s take a closer look at the three sections of the income statement.

Revenues

As the name suggests, this section of the income statement totals sales for a period of time (quarterly or yearly). Depending on the nature of the business, revenues can be generated by selling tangible goods or services. Are revenues increasing, decreasing or remaining the same?

Expenses

The two most common types of expenses are the cost of goods sold and the SG&A (selling, general and administrative) expenses.

The cost of goods sold refers to all the direct costs linked to the production of the good, such as materials and labor used to produce the good. Other costs such as sales force and distribution costs are not included because they are not directly associated with the production of the good. Are the cost of goods sold increasing which could reduce future profitability?

The SG&A expenses refer to the operating expenses of a company. They include all the costs it takes to run the business, such as management salaries, marketing, and sales force. Ideally these costs will be dropping as a percentage of sales and be lower than their competitors.

Profit

Profit is equal to the difference between revenues and the expenses required to generate that revenue. On the income statement there are different measures of profitability which provide useful information for the investor.

Gross Profit is equal to the difference of the revenues and the cost of goods sold. It refers to the profit the company made due to the good or service sold. Increasing gross profit is a good sign.

Operating Profit, also known as operating income, or earnings before interest and taxes (EBIT), is equal to the difference between the revenues and expenses (both cost of goods sold and SG&A expenses). It represents the profit the company made due to its operations and should be strong if the company is in a good competitive position.

Net income refers to a company’s profit once all the costs have been deducted, including taxes and interest. This is also referred to the “bottom line”. This is what belongs to the stockholders.

By dividing the net income by the number of outstanding shares you can determine the earnings per share (EPS) which is the actual profit (or loss) left for the shareholders. The EPS is what stock analysts are most interested in. If the stock analysts have an expectation for a certain EPS and that expectation is missed, the share price of the stock will most likely drop (however, if you have invested in a company with strong fundamentals and are a long term investor you should not be overly concerned because short term fluctuations do not affect you).

Since profitability is a key aspect for the evaluation of a stock, you should master the ability to interpret income statements.

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