Looking at Company Financial Statements and Ratios: The Income Statement

When you are looking to invest in individual stocks, it makes sense to look at the company’s financial statements (or at least the company profiles on Yahoo! Finance and Morningstar). This series “Looking at Company Financial Statements and Ratios” tries to break down some of the things you should look at to help understand how the company is doing and whether it is priced fairly. Last time, we looked at the balance sheet. This week, we’re going to look at the basics of the income statement.

The Income Statement

An income statement is the total of a company’s total income and expenses over a given period of time. Once all revenues are added and all expenses subtracted, the statement reaches net income or profit for the period. Usually the period is for a fiscal year or quarter, but companies may also use monthly and year to date statements to track their performance. Other terms used are the profit and loss statement, statement of operations, and the statement of revenue and expense. When the news media starts talking about “earnings” for a company, they are talking about the results of the income statement.

Income statements are broken into operating and non-operating sections. The operating section deals with a business’s core activities; the non-operating section deals with activities that are incidental to the company’s main activities. So if you have a restaurant, food and labor expenses would be found in the operating section. Interest earned on the bank balance would be considered non-operating.

Net Sales, Cost of Sales and Gross Profit

The number at the top of the income statement is the net sales or revenue. This is the amount of income a company received for its core function. On the income statement, most companies report this as one number. You can often find additional information about revenues of particular business lines or geographic regions in the supporting statements. If you are looking at a company’s income statements, start with the net sales. Are sales growing, maintaining their level, or declining? Are they on an even or uneven path? What factors seem to be driving sales?

The cost of sales refers to the cost to get or make the goods or services the company sells. This can include materials, labor and allocated overhead. Not every company will report a cost of sales.  If a company has cost of sales, they will also generate a gross profit. The percentage of sales left after cost of sales is called the gross margin. Lower cost of sales is better, as a company that can control the cost of sales has more money to cover other expenses. Some industries have lower cost of sales than others. Manufacturing companies will have much larger cost of sales than most service companies.

Read our article on gross profit margin, profit margin and net margin.

Operating Expenses and Operating Profit

Not every expense can be directly attributed to revenues. In the operating expense section, you will always find sales, general and administrative expenses (SG&A). These are the expenses that are generated in promoting and managing the company.  While a lot of companies need to advertise widely, companies that can control costs on SG&A perform better than those who don’t.

It’s important when looking at expenses to note that not all expenses are cash expenses. Accounting conventions include the concept of noncash expenses. While a noncash expense decreases net income, it doesn’t affect the amount of cash the company is generating. The most common of these is depreciation. Depreciation is the expense of using a fixed asset. If a company buys a truck for $40,000, they don’t expense the entire $40,000 the year they buy the truck. They expense it over the period of time they expect to use the truck. So if the expected period is 5 years, the company might expense the depreciation of the truck at $8,000 per year. This is called straight-line depreciation. The company might use an accelerated depreciation schedule instead. In accelerated depreciation, more depreciation is expensed at the beginning and less at the end of the 5 years.

Amortization and depletion are similar to depreciation but apply to intangible assets and natural resources respectively. Companies can put depreciation, amortization and depletion in the cost of goods sold or operating expense section. They will also be entered on the cash flow statement. These expenses are important to note because they do not reflect money going out of the company during the income statement period. A company with negative earnings and a lot of noncash expenses may still be in a solid financial position.

There are several other operating expenses that you can generally find on the income statement or supporting statements: rent and operating leases, research and development, and pension expenses. Then there’s the all-encompassing other operating expense. Once you have subtracted all of a company’s operating expenses, you are left with operating profit. This is the results from core operations. It doesn’t include one important expense that a lot of companies carry: interest expense. If a company emphasizes operating profit rather than net profit, check the interest expense.

Non-Operating Activities and Net Profit

Non-operating activities reflect the things a business does outside of its main line of business. Non-operating activities start with the effects of borrowing and investing money. The biggest non-operating expense is usually interest expense, which is found right under operating expenses. Heavy interest payments indicate a lot of debt. If you see a lot of interest, check the balance sheet and the notes to understand the debts the company has. Some companies also have considerable income from investing, even if investment is not the major focus of the company’s operations.

One thing to look for in a company’s non-operating activities is income or expense from discontinued operations and restructuring charges. Some companies have these every year, and they can have a large effect on a company’s bottom line. Investors should check the supporting statements to understand the extraordinary items and their impact on future earnings.

After the rest of the expenses and income are accounted for, income statements show pretax income and income tax expense. Income taxes are directly reflective of the company’s performance, but tax accounting and financial reporting rules differ. The differences result in both current and deferred income tax expense and credits.

The final part of an income statement is the net profit or earnings of the company. Net income will feed into the balance sheet as retained earnings in the equity section. More net income means more value for stockholders.

Healthy companies generate good earnings. Rising earnings usually result in rising stock prices, since this means the company was able to generate revenue in excess of any additional spending. Sometimes, though, even healthy companies with healthy cash flow can show a loss. Investors should look for earnings trends over several years. Why did the loss happen? Does a loss show an aberration or the start of a worrying trend?

Why Should You Care?

If you want to start understanding how a company is doing, start with their income statement. Look for trends in their income, expenses, and earnings. Use common-sizing and ratios to see how their expenses and profits compare to their competitors or change over time. Get a feel for what you can expect from a  company’s operations. There’s a reason so much of the investment press focuses on earnings.

But just because earnings and revenue are the focus doesn’t mean you can stop there. Make sure you are checking cash balances and cash flows over time. Watch the balance sheet for trends. Read the notes. Earnings can be manipulated. You need to understand how the entire financial statement interacts and look at all of it to understand the state of the company.

Image courtesy of Gualberto107 at FreeDigitalPhotos.net

This article is for information purposes only.

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