Introduction to the Income Statement
At its most basic level, the
Income Statement lists a firm's
Revenue, operating and other expenses, and how much money was left over in some
currency during a specific period of time. This simplicity makes the Income Statement the most intuitive of the
accounting tables in a
financial report.
The Income Statement typically covers a three-month
fiscal quarter or a
fiscal year.
To facilitate comparisons, a quarterly Income Statement will show, side
by side, data for the designated quarter and for the year-earlier
period. Annual Income Statements will list results for two or three
consecutive years.
The bottom-line figure, which is called either
Net Income
or Net Earnings, is expressed both in absolute terms (dollars, or
another currency) and in an amount related the number of common shares
the company has outstanding (dollars per share).
Earnings Per Share gets the most attention in the financial press.
Assumptions
made by corporate management can have a great effect on the Income
Statement's figures. Earnings, which might appear to be the result of
mere arithmetic, are more subjective that it might appear.
Revenue
The
"top-line" of the Income Statement lists the company's Revenue, or
Sales, during the quarter or year. The notes accompanying the financial
statements will indicate what rules the company followed to recognize a
transaction as Revenue. The rules will address questions such as: what
if the company sells an item to wholesaler that can return the item if
it is not bought by a consumer? What if the company receives funds for a
service or product it will deliver in the future.
Determining Revenue is more complicated than counting the cash in the till each day.
Operating Costs or Expenses and Operating Income
The
next section of the Income Statement lists the expenses that can be
tied, directly or indirectly, to the creation and sales of the company's
products.
The
Cost of Goods Sold (CGS)
(a/k/a Cost of Revenues) includes the labor and material costs to
create the company's products. It is usually the largest Operating
Expense.
Depreciation of the equipment and facilities used for company operations might be included in
CGS,
or it might be broken out separately. This non-cash expense reflects
decreasing value over time of the company's capital equipment.
Other typical operating expense categories are
Research and Development (R&D);
Sales (i.e., marketing), General and Administrative (SG&A); and
non-recurring Special Operating Charges (less frequently Gains). The markdown (or write-down) of the value of
Inventory is an example of a special charge. This is one example of an
Asset being recognized as
impaired.
Operating Income is found by subtracting Operating Costs/Expenses from Revenue.
Non-Operating Income and Expense
Non-operating
items might include categories such as Gains or Losses on Investments,
Gains or Losses on Asset Sales, Net Interest Income or Expense, and the
catchall miscellaneous category.
The company's Pre-tax Income, or
Taxable Income, is determined by adding the Non-operating gains to, and subtracting the Non-operating losses from, Operating Income.
A
provision for
Income Taxes reduces Income to the bottom-line figure.
Net Income
Net Income is divided by the number of
Common Shares Outstanding to compute the widely reported
Earnings per Share (EPS).
Sometimes non-recurring gains and losses are excluded from the EPS
values one sees in the newspaper or on TV, so the analyst has to treat
these values with extreme caution.
Income Statement Example
While
most Income Statements have the same general structure, they can differ
substantially in the details. The following is a fictitious example,
which we use below to illustrate what can be learned from the Income
Statement.
GCFR Inc.
(Millions of $) |
| Quarter ending
30 June 2006 | Quarter ending
30 June 2005 | Year ending
30 June 2006 | Year ending
30 June 2005 |
| Revenue |
| 52.2 | 43.9 | 198.1 | 170.0 |
| Op expenses |
|
|
|
|
|
| CGS | (39.1) | (33.0) | (149.1) | (127.1) |
| Depreciation | (1.0) | (1.3) | (4.0) | (3.9) |
| R&D | (2.1) | (1.8) | (8.2) | (6.0) |
| SG&A | (3.2) | (1.7) | (11.1) | (7.1) |
| Other ("Special") | (0.1) | (0.2) | (0.4) | (0.8) |
| Operating Income |
| 6.7 | 5.9 | 25.3 | 25.1 |
| Other income |
|
|
|
|
|
| Gains on asset sales | 0.5 | 0.9 | 2.0 | 3.1 |
| Gains on investments | 2.4 | 1.6 | 9.0 | 5.8 |
| Net Interest and other income | (1.2) | (1.0) | (4.1) | (4.8) |
| Pretax income |
| 8.4 | 7.4 | 32.2 | 29.2 |
| Provisions for Income taxes |
| (2.9) | (2.6) | (12.1) | (11.9) |
| Net Income before adjustments |
| 5.5 | 4.8 | 20.1 | 17.3 |
| Equity income less minority interests | 0.0 | 0.0 | 0.0 | 0.0 |
| Discontinued operations and Accounting changes | 0.0 | 0.0 | 0.0 | 0.0 |
| Net Income |
| 5.5 | 4.8 | 20.1 | 17.3 |
| Earnings per Share ($/sh) |
| $0.46/sh | $0.41/sh | $1.70/sh | $1.51/sh |
| Shares outstanding (M) |
| 12.00 | 11.60 | 11.82 | 11.43 |
What Can be Learned from the Income Statement?
The Income Statement can reveal a lot about an organization's operations. To gain those insights,
financial analysts
measure the rate of change for key Income Statement items, and they
calculate various ratios using data from the Income Statement, other
financial statements, and the supporting
Notes.
The
importance of any particular ratio depends on the size, type, and
condition of the company being evaluated. Changes in the ratios over
time are often more revealing than the values themselves. It can also
be useful to compare ratios for one company with other firms in the same
industry.
GCFR uses the ratios described below.
Revenue Growth
Changes
in the company's Revenue can be characterized in various ways. To
eliminate seasonal factors, it is common to compare Revenue in one
quarter to Revenue in the same quarter of the previous year.
Less
widely used, sequential quarterly Revenue growth compares Revenue in
the current quarter to Revenue in the immediately preceding quarter.
To
smooth out the trend, we compare Revenue during the previous four
quarters to Revenue during the prior four quarters. We refer to this
growth rate as "
year-over-year" growth or "trailing 4-quarters."
Readers should be aware that there are alternative definitions for
these terms. The year in these calculations will coincide with the
fiscal year only 25 percent of the time.
GCFR Inc.
(Millions of $) | Revenue Growth |
| Quarters ending June 2006 and June 2005 | (52.2 - 43.9)/43.9 = 18.9% |
| Years ending June 2006 and June 2005 | (198.1 - 170.0)/170.0 = 16.5% |
Operating Expenses/Revenue
The
ratio of each Operating Expense item to Revenue shows what the company
spent to realize each sales dollar. We make these calculations for the
current quarter and for the last four quarters. If the company is able
to achieve efficiencies of scale as it increases Revenue, costs as a
percentage of Revenue will drop, and more of each sales dollar will
reach the bottom line as earnings.
We subtract
CGS/Revenue from 1 to determine the
Gross Margin.
Alternatively, this can be expressed as (Revenue- CGS)/Revenue. A high
Gross Margin is preferred, as it indicates that the company can sell
its goods and services for much more than the production cost. We find
it more useful to compare the Gross Margins from year to year, rather
than from quarter to quarter because the data for shorter periods can be
volatile.
For fictional GCFR Inc., using figures from the sample Income Statement above:
GCFR Inc.
(Millions of $) | Gross Margin |
| Quarter ending June 2006 | 1 - (39.1/52.2) = 25.1% |
| Quarter ending June 2005 | 1 - (33.0/43.9) = 24.8% |
| Year ending June 2006 | 1 - (149.1/198.1) = 24.7% |
| Year ending June 2005 | 1 - (127.1/170.0) = 25.2% |
When the data is available, we separately calculate
Depreciation/Revenue,
R&D/Revenue, and
SG&A/Revenue. Depreciation is included in
CGS for some firms, and some firms don't engage in R&D.
As
was mentioned for Gross Margin, we prefer to compare the expense ratios
from year to year, rather than from quarter to quarter. Seemingly
random variations in shorter periods can obscure the underlying trends
and lead to erroneous conclusions.
GCFR Inc.
(Millions of $) | Depreciation/Revenue | R&D/Revenue | SG&A/Revenue |
| Quarter ending June 2006 | 1.0/52.2 = 1.9% | 2.1/52.2 = 4.0% | 3.2/52.2 = 6.1% |
| Quarter ending June 2005 | 1.3/43.9 = 3.0% | 1.8/43.9 = 4.1% | 1.7/43.9 = 3.9% |
| Year ending June 2006 | 4.0/198.1 = 2.0% | 8.2/198.1 = 4.1% | 11.1/198.1 = 5.6% |
| Year ending June 2005 | 3.9/170.0 = 2.3% | 6.0/170.0 = 3.5% | 7.1/170.0 = 4.2% |
Finally, the ratio of total
Operating Expense to Revenue gives an indication of the company's overall profitability.
GCFR Inc.
(Millions of $) | Operating Expense / Revenue |
| Quarter ending June 2006 | (39.1 + 1.0 + 2.1 + 3.2 + 0.1) / 52.2 = 87.2% |
| Quarter ending June 2005 | (33.0 + 1.3 + 1.8 + 1.7 + 0.2) /43.9 = 86.6 % |
| Year ending June 2006 | (149.1 + 4.0 + 8.2 +11.1 + 0.4) / 198.1 = 87.2% |
| Year ending June 2005 | (127.1 + 3.9 + 6.0 + 7.1 + 0.8) / 170.0 = 85.2% |
Operating Income and Net Income Growth
Quarter-over-quarter and year-over-year Income growth rates can be calculated in the same way as Revenue.
GCFR Inc.
(Millions of $) | Operating Income Growth | Net Income Growth |
| Quarters ending June 2006 and June 2005 | (6.8 - 6.1) / 6.1 = 11.5% | (5.5 - 4.8) / 4.8 = 14.6% |
| Years ending June 2006 and June 2005 | (25.3 - 25.1) / 25.1 = 0.8% | (20.1 - 17.3) / 17.3 = 16.2% |
Income Tax Rate
The
ratio of Provisions for Income Taxes to the Income before Taxes should
be checked to see if the tax rate has changed. We've seen companies
trumpet increased earnings that were due primarily to a change in the
tax rate (and had nothing to do with the fundamental functioning of the
business). Because the quarterly data can be quite volatile, the annual
tax rate is better suited for earnings models.
GCFR Inc.
(Millions of $) | Income Tax Rate |
| Quarter ending June 2006 | 2.9/8.4 = 34.5% |
| Quarter ending June 2005 | 2.6/7.4 = 35.1% |
| Year ending June 2006 | 12.1/32.2 = 37.6% |
| Year ending June 2005 | 11.9/29.2 = 40.8% |
Revenue/Assets
The
ratio of Revenue during a quarter or year to Total Assets indicates how
effectively and efficiently the company is employing its Assets to
generate sales. The key is to look for changes: is the efficiency
increasing or decreasing?
Total Assets is a figure listed on the
Balance Sheet.
When making the Revenue/Assets calculation, the amount of Assets at the
end of the period can be used. However, a more representative
calculation can be made by averaging the Asset values at the beginning
and end of the period. The difference between these two approaches is
more significant for small, rapidly growing companies.
Note
that Revenue/Assets for a quarter will be about 25 percent of
Revenue/Assets for the year. We multiply the quarterly result by 4 to
make it more comparable with annual data. However, this approach can
produce misleading results if sales are highly seasonal. In this case,
an analyst would want to look at historical trends to determine the
typical distribution of Revenue over the year.
Let's assume a series of
Balance Sheets for fictional GCFR Inc. listed the following values for Total Assets:
| Date | Total Assets ($M) |
| 9/30/2004 | 187.7 |
| 12/31/2004 | 192.5 |
| 3/31/2005 | 197.4 |
| 6/30/2005 | 202.5 |
| 9/30/2005 | 207.7 |
| 12/31/2005 | 213.0 |
| 3/31/2006 | 234.0 |
| 6/30/2006 | 255.0 |
We compute Revenue/Assets as shown below:
GCFR Inc.
(Millions of $) | Revenue/Assets |
| Quarter ending June 2006 | 4*52.2/[0.5*(255.0+234.0)] = 85.4% |
| Quarter ending June 2005 | 4*43.9/[0.5*(202.5+197.4)] = 87.8% |
| Year ending June 2006 | 198.1/[0.5*(255.0 +202.5)] = 86.6% |
Operating Profit or Net Operating Profit after Taxes
Operating Profit
is a variation of the Operating Income item on the Income Statement.
We calculate it by excluding unusual operating gains and losses from
Operating Income and adjusting the remainder to reflect Income Taxes.
Operating Profit (a/k/a NOPAT) = (Operating Income + Special Charges) * (1 - Income Tax Rate)
Operating
Profit differs from Net Income in that it excludes Non-Operating income
and expenses, such as interest and investment returns.
At GCFR, we calculate and track
Operating Profit's average annual growth rate
over the last 16 quarters. This growth rate should be less volatile
than the Net Income growth rate because special items are excluded and
the longer averaging time (16 vs. 4 quarters).
Net Operating Profit after Taxes/Revenue
NOPAT/Revenue is a good measure of the profitability of the company's core business.
It would be rare for us to compute this ratio with quarterly values, but we include quarter and annual
NOPAT/Revenue values in the table below to show how the calculation would be made.
GCFR Inc.
(Millions of $) | NOPAT/Revenue |
| Quarter ending June 2006 | (6.7 + 0.1) * (1 - 0.345) / 52.2 = 8.5% |
| Quarter ending June 2005 | (5.9 + 0.2) * (1 - 0.351) / 43.9 = 9.0% |
| Year ending June 2006 | (25.3 + 0.4) * (1 - 0.376) / 198.1 = 8.1% |
| Year ending June 2005 | (25.1 + 0.8) * (1 - 0.408) / 170.0 = 9.0% |
Net Income/Revenue
Net
Income as a percentage of Revenues (a/k/a Net Margin) is a more
complete measure of profitability, but it can be swayed by extraordinary
non-operational changes.
GCFR Inc.
(Millions of $) | Net Income/Revenue |
| Quarter ending June 2006 | 5.5/52.2 = 10.5% |
| Quarter ending June 2005 | 4.8/43.9 = 10.9% |
| Year ending June 2006 | 20.1/198.1 = 10.1% |
| Year ending June 2005 | 17.3/170.0 = 10.2% |
Net income/Stockholders' Equity
This
a basic return-on-investment ratio. Stockholders have a right to
expect that the company will make more for each dollar of investment
than lower risk securities.
Stockholders' (or Shareholders') Equity is listed on the
Balance Sheet.
When making the Net Income/Equity calculation, the Equity at the end of
the period can be used. However, a more representative calculation can
be made by averaging the Equity values at the beginning and end of the
period. The difference between these two approaches is more significant
for small, rapidly growing companies.
Note that Net
Income/Equity for a quarter will be about 25 percent of Net
Income/Equity for the year. We multiply the quarterly result by 4 to
make it more comparable with annual data. However, this approach can
produce misleading results if Net Income is highly seasonal. In this
case, an analyst would want to look at historical trends to determine
the typical distribution of Net Income over the year.
Let's assume a series of
Balance Sheets for fictional GCFR Inc. listed the following values for Stockholders Equity:
| Date | Stockholders Equity ($M) |
| 9/30/2004 | 94.3 |
| 12/31/2004 | 96.7 |
| 3/31/2005 | 99.2 |
| 6/30/2005 | 101.7 |
| 9/30/2005 | 104.3 |
| 12/31/2005 | 107.0 |
| 3/31/2006 | 120.5 |
| 6/30/2006 | 134.0 |
We compute Net Income/Equity as shown below:
GCFR Inc.
(Millions of $) | Net Income/Equity |
| Quarter ending June 2006 | 4*5.5/[0.5*(134.0+120.5)] = 17.3% |
| Quarter ending June 2005 | 4*4.8/[0.5*(101.7+99.2)] = 19.1% |
| Year ending June 2006 | 20.1/[0.5*(134.0+101.7)] = 17.1% |
Return on Invested Capital (ROIC)
ROIC
is a more subtle return-on-investment ratio that provides insight into
how much the company earns on each dollar of capital provided by
shareholders and lenders. We use
NOPAT for the last four quarters as the numerator, and
Invested Capital, which we discussed in the
Balance Sheet tutorial, as the denominator.
From the
NOPAT/Revenue
discussion above, we can determine that the fictional GCFR Inc. had a
4-quarter NOPAT of (25.3 + 0.4) * (1 - 0.376) = $16.0 million as of 30
June 2006.
Invested Capital measures the investment,
whether raised by stock sales or taking on debt, that is actually
deployed (i.e., not sitting in the bank). The definition for this term
that we use is Stockholders' Equity, plus Short- and Long-Term Debt,
minus Cash as the denominator. These values are listed on the Balance
Sheet.
Note:
This post was originally published on 25 October 2006. It was revised
on 1 September 2008, 17 January 2009, 19 April 2009, 10 July 2010, and 4
August 2010.
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