The income statement: how to read

Key takeaways:

The income statement shows how much a company earned or lost during the year (or quarter).

An income statement matches the revenues earned from selling goods and services, against all costs and expenses incurred in the operation of the company. The difference is what we call net income (or loss).

On top of the Income statement, we find the revenue (or net sales)  which is called “the top line”. From the top line, all costs and expenses are deducted until we arrive at the net income, also called “the bottom line”.

Let us start by looking at the top line:

Net sales (revenue)

Net sales are the income a business has from its normal operations. Usually from the sale of goods or services provided.

Cost of goods sold (C.O.G.S)

These are the costs that a company incurs to purchase and convert raw materials into the finished good that it sells.

These product costs have three components:

  • Direct materials: Materials directly used to produce the product.
  • Direct labor: Labor costs directly involved in the production of the product.
  • Manufacturing overhead: These are the operating costs not directly linked to the finished product. For example, Rent, electricity, supplies, etc…

Gross margin (gross profit)

Gross margin = Net sales – cost of goods sold

Gross margin represents the actual direct profit from sales after considering production costs. Gross margins percentages can be compared over the years to see whether or not the business is getting more efficient in the production of their goods.

revenue examole

Operating expenses

Includes the normal recurring expenses a business incurs by running its normal operations. (often abbreviated as OPEX)

Let us look at some important parts of operating expenses:

Depreciation and amortization

These are non-cash expenses. It captures each year’s decline in value of the assets.

For example, an asset with an estimated useful life of 20 years would be amortized over a period of 20 years using the straight-line method of depreciation.

The accumulated amount of depreciation can be found on the balance sheet.

Selling, General and administrative expenses (SG&A)

This section includes all direct and indirect selling expenses and all general and administrative expenses. Examples include commissions, advertising, office payroll, and office expenses, executives’ salaries, etc..

operating expenses

Operating income (or loss)

Operating income, also referred to as EBIT (= Earnings Before Interests and Taxes) 

Operating income shows the investor the income from a company’s normal operations after deducting all operating expenses such as COGS, Depreciation and amortization, and SG&A.

Operating income is an important indicator of the operating performance of any given company.

Other income (or expense)

Other income (or expense) is the income (or expense) incurred from other activities rather than the main business activities. For example, dividends or interest received from the company’s investments.

Let us look at some important parts of other income:

Dividend and interest income

This is an additional source of revenue that comes from dividends and interest a company receives from its equity investments.

Interest expense (fixed charge)

The interest expense paid on debt is sometimes called a “fixed charge”. It must be paid periodically, whether or not the business is profitable. Interest expense is the cost of doing business.

So a loan interest payment is shown on the income statement. The principal payment on a loan will not be shown on the income statement as it is a deduction on a liability, which is reported on the balance sheet. The cash transfer of the principal payment will be stated on the cash flow statement.

income before extraordinary loss

Income before income taxes and extraordinary loss

Also referred to as EBT (= Earnings Before Taxes)

Let us look at some important parts of EBT:

Income tax expense

A tax expense is a liability owed to the government within a given period. Tax credits, tax-free income, and nondeductible expenses all have an impact on the overall effective tax rate.

Income before extraordinary loss

The amount by which the revenue exceeds all the expenses for the year (or quarter).

Extraordinary items, net of tax

Under usual conditions, income before extraordinary loss would represent the actual income figure for the year. However, the income statement isolates unusual and infrequent events, net of their tax effect.

Net income

Net income

The revenue after all costs are deducted is known as net income or “the bottom line”. This represents the profit for the year (or quarter). If net income is negative, the company records a loss for the year (or quarter).

Net income plays an important part in many metrics such as the P/E ratio (price to earnings). Other important ratios can be found here.

Income statement example

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