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Lesson 2: The Income Statement

Income Statement, Cash Flow, Balance Sheet, Fundamental Analysis

Income Statement, Cash Flow, Balance Sheet, Fundamental AnalysisIn the previous article we have seen the balance sheet, now we see the income statement. The income statement is one of the major financial statements and contains the financial results of a company such as revenue, earnings and earnings per share. The income statement shows how much money the company generated (revenue), what it has spent (expenses) and the difference between the two values (profit) for a specified period that, usually, is 3 months (quarterly) or 12 months (yearly).

When we decide to analyse the fundamentals, the income statement allows us to know how the company is working; in other words, if the company is generating money. Companies should be able to earn more money than they spend. Otherwise, they will not stay in business for a long time.

 

Revenue

Revenues, or total sale, are the simplest part of the income statement and is used as an indication of earnings quality. Usually, there is only one number that represents the amount of money a business brought in a given period.

However, several companies break down revenue by business segments or geographical areas to clarify how much was generated by each division. With a separate revenue, the income statement is much easier to analyse and allow us to make more accurate predictions about the future company growth.

Continuity of revenue and their year-to-year increase is the best way a company has to grow. Temporary increases, such as those resulting from the short-term promotion, should be considered in proper balance and, in any case, always take into account the price-to-earnings ratio.

There are other several financial ratios we can use, the most important are: the gross margin (it measures how profitable a company can sell its inventory) and the profit margin (it measures what percentage of sales is made up of net income).

 

Expenses

In a company there are many kinds of expenses, the two most common are: the cost of goods sold and selling, general and administrative expenses.

The cost of goods sold, often abbreviated COGS, is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company. In other words, this is the amount of money the company spent on labour, materials, and overhead to manufacture or purchase products that were sold to customers during a given period. The purpose of the COGS calculation is to measure the real cost of producing goods that customers have purchased over a given period.

The selling, general and administrative expenses, or SG&A, includes marketing, salaries, utility bills and other general costs. Some corporate expenses, such as research and development, are vital to future growth and should not be cut, even though this may lead to a better performance ratio. Finally, there are financial costs, in particular taxes and interest payments, which must be considered.

 

Profit

Profit is given by a simple formula: total revenue minus total expenses. There are several subcategories that are used by investors for understanding how the company is performing.

The Gross Profit is calculated as revenue minus cost of sales. Companies with high gross margins will have much money to spend on other commercial activities, such as marketing to advertise own products.

Operating profit (Earnings Before Interest and Taxes, EBIT) is equal to revenues minus the cost of sales and selling, general and administrative expenses (SG&A). High operating margins can mean the company has adequate control of costs, or that sales are increasing faster than operating costs.

Operating profit measures how much cash the business throws off, and it is a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings.

Company with a high-profit margin means that it has one or more advantages over its competition. Companies with high net profit margins have a more significant cushion to protect themselves during the hard times. In fact, companies with low-profit margins can get wiped out in a period of crisis.

Below, you can see a sample Income Statement (click to enlarge).‚Äč

Income Statement, fundamental analysis

In the next article, we will see the Cash Flow Statement.

 

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