Income statements are crucial to understanding a company’s financial performance. An income statement, also known as a profit and loss statement, is a financial document that shows a company’s revenues and expenses over a specific period of time. It is used to calculate a company’s net income, which is the amount of money it made or lost during that period. The income statement is important because it provides investors and analysts with information about a company’s financial performance, including its ability to generate revenue, control costs, and make a profit. It is also used to assess the company’s liquidity, profitability, and solvency, which are important indicators of a company’s overall financial health.
Revenue
– Cost of Goods Sold
———————————-
Gross Profit
Operating Expenses
– Selling, General, Expenses
– Research & Development
– Depreciation
———————————-
Operating Profit
– Interest Expense
– Gain (Loss) Asset Sales
– Other
———————————-
Income Before Tax
– Income Taxes Paid
———————————-
Net Earnings
Revenue
The “top line” on the income statement is always revenue or sales, the amount of money that came into the business during the period, generally on a quarterly basis. If the business makes car parts, then the total revenue is based on how much it sold during the period. An important lesson to remember is that revenue does not equate to profit, which depend on the costs (aka expenses) tied to generating the revenue.
Cost of Goods Sold (COGS)
The lower the better is a good rule to follow. COGS also known as cost of revenue is an important metric of company health and key to determine gross margins when searching for long-term investments.
Gross Profit + Margin
Total revenue less the cost of goods sold equals gross profit. This number shows how well a company turns revenue into earnings. Alone the number tells relatively little about a company, but when taken against revenue, the gross profit margins tell investors a lot about a businesses worthiness.
Gross Profit = Revenue – Cost of Goods Sold
Gross Profit Margin = Gross Profit ÷ Total Revenue
Higher gross margins can signal competitively durable advantages. In other words, companies with high gross margins tend to have a narrow or wide competitive advantage. Apple’s gross margin as of 2023 is 43%, if you need a reference.
Operating Expenses
Right beneath the gross profit on the income statement are operating expenses. These include all the costs tied to running of a business. From selling and administrative to research and development, depreciation, and others. Each of these line items should be judged against gross profits.
Selling, General, & Administrative: These include management salaries, advertising, travel, legal, commissions, payroll, and similar costs. Anything under 30% of gross profit is exceptional. Anything over 80% would be problematic.
Research & Development: Consistent businesses, even technology firms, do not generally need to reinvest heavily in R&D in order to stay competitive. If one does, or if any industry does, even if its market value is growing, that is a red flag. The one caveat is if this expense remains the same or decreases with technological advances.
Depreciation: Hard assets are a real cost of doing business that financiers can use to pile debt onto a company’s books. In calculating working capital, do not overlook this expense.
Interest Expense
When a company piles on debt, there is an expense for interest it pays out. The more debt, the more interest. Sometimes, companies can add debt at low interest rates when money is cheap. As a general rule of thumb, total debt to income should not exceed 5x in non-financial businesses. For most companies, paying less than 15% of operating income would be best.
Earnings (BITA + Net)
Income is what’s left after a company’s paid all its expenses have been paid. The approximate taxes paid by corporations that are publicly traded equates to around 30%. Individual situations may apply like how many companies use exotic tax structures to avoid paying them around the world. Net earnings matter in context of the businesses ability to use them to grow. Some companies grow top line fast as they learn how to control costs, only later becoming efficient. However, a good rule of thumb is to follow the earnings and don’t bet on companies losing money consistently.
