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.
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.
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 to improve on. Thus, companies typically can grow no faster than the growth of 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 S G&A expenses, as a percentage of sales, is watched closely to detect signs, both positive and negative, of managerial efficiency.
- Operating Income: Deducting S G&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. When they are of this nature, investors need to take these special items, which can distort evaluations, into account when making inter-annual profit comparisons.
- 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.
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 X Y Z, 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 a very efficient management effort.