Maybe you remember that in 2002, both the CEO and the CFO of the WorldCom were indicted for $3.3 billion in profits that were improperly recorded. The the largest accounting fraud in US history. Basically they falsified the date presented in the Income Statement to make the company appear more profitable that really was.

What is an income statement

So, what is the income statement and what are the information and metrics that it provides? And, why do analysts and companies management alike focus so much of their attention on it so much so that WorldCom executives were willing to risk just about everything to manipulate it?

If you watch or read the business news during certain times of the year typically during the month following the end of any calendar quarter the headlines are dominated by company earnings announcements and press releases.  Take this example from Apple:

Apple announced today financial results for its fiscal 2014 first quarter the company posted record quarterly revenue of $57.6 billion and quarterly net profit of $13.1 billion or $14.50 per diluted share. Gross margin was 37.9% International sales accounted for 63% of the quarter’s revenue”

We should take special note of the key metrics that Apple identifies at the very opening of this press release: revenue, gross margin, net profits, earnings per diluted share, international sales. Each and every one of these metrics is either explicitly disclosed on derived from the company’s income statement.

Measuring income

GAAP (the generally accepted accounting principles) require the use of accrual accounting, as a result the recognition of both revenues and expenses and therefore profits does not necessarily occur when cash is either received or paid out.

Revenues are generally recognized when they have been earned and realized, meaning that the company has essentially done what is promised a customer it will do and the customer has provided either payment or promise of payment and accounts receivable to the company.

Expenses can be recognized in different ways and at different times depending on the particular circumstances, but – generally speaking – expenses are matched with their underlying revenues provide as accurate a profit picture as possible.

The important point to note here is that revenue and expenses can be recognized at different points in time depending on the facts and circumstances and they may or may not be closely tied to the actual receipt payment of cash.

Income statement structure overview

There are many variations in the financial statement titles terminology and the level of detail provided but income statements report the same basic type of information and are similarly organized.

The starting point for any income statement of the so-called top line is revenue, which is the amount of sales to customers an organization generated during the particular financial reporting period, reduced by any sales returns or other discounts.

Underneath revenues a typical income statement provides what is known as cost of sales the cost of goods sold: direct labor, direct materials and manufacturing overhead.

Direct labor is the labor used in the process of manufacturing a company’s products or for service providers, direct materials are the cost of the raw materials included in the particular goods sold and, finally, manufacturing overhead includes certain indirect costs that are allocated to the products sold.

Gross profit or gross margin

Most firms disclose the gross margin explicitly on the face of their income statements while others don’t, in those cases however it is easily calculated and many account analysts use reported gross margin to compute something known as the gross margin percentage.

To compute the gross margin percentage you take the amount of reported gross margin in dollars divided by the sales revenue again reporting dollars which gets you a percentage.  The gross margin percentage provides a widely cited measure profitability and allows for comparisons between different periods of operations and between different companies.

Following gross margin on the income statement firms deduct other costs and expenses generally known as operating expenses. This includes almost all other costs and expenses not included in cost of goods sold and include things like selling and marketing costs delivery expenses most appreciation and finally expenditures on research and development.

As a rule of thumb operating expenses generally range from 15 to 20% of revenues although that depends on the particular company or organization and as firms grow larger they are usually able to reduce this percentage of operating expenses as they experience economies of scale and are able to leverage their larger sizes.

The operating income or loss

Often called income or loss from operations which is the result of deducting offering expenses gross margin it is often referred to as EBIT or earnings before interest and taxes.  By its very name, this figure is intended to provide us with the amount of income or loss an organization actually generated from its normal and recurring activities.

While revenues are extremely important to be sure they ignore operating expenses that could theoretically more than eliminate reported sales figures. You can imagine a firm with really high sales but with really high expenses.  These results could be very relevant to investors or prospective investors in either or both companies.

Other non-operating income or expense

This might include things like interest income the company may have earned on its investments any interest expense the company may have incurred on outstanding debt. In any case because these numbers are not related to an organization does day-to-day, they appear below operating income or what is often called below the line.

To the extent a company has other income or losses during a particular period that are not related to daily operations maybe the gain or loss realized from the sale of certain equipment these two are reflected in this particular section the income statement.

So, to reiterate,  income statements begin with net sales revenues, then they deduct cost of sales resulting in gross margin, next we subtract various operating expenses leading to operating income, we then add or subtract the so-called below the line income or expenses which gives us the next line on the income statement income before taxes.

The income tax

The income tax expense in income statements is not equal to the taxes paid during the year.  Because of the accrual accounting he income tax expense reflected in income statements is not simply what we owe in taxes right now. What appear are the taxes due on the tax return, and this also includes any future tax consequences of revenues and expenses we are reporting today.

The income tax expense information captures all of an organization’s income taxes federal state local and even international for those firms doing business globally. Because most foreign countries have different corporate tax rates, we will generally find that the actual tax rate in an income statement different than the statutory corporate tax rate.

Keep in mind regarding income taxes is that it is possible that the income taxes could actually be a positive figure what is known as an income tax benefit as opposed to an expense. Usually this happens when companies are reporting losses for which they can actually benefit under corporate tax law.

The bottom line

Once taxes are deducted from the income before taxes the result is as would be expected net income often called the bottom line.

While the bottom line is certainly important and widely cited in the popular press it might include one-time income or expenses that are not part of recurring operating results, which are what we really want to understand and evaluate and that is why consider operating income.

Earnings-per-share

Literally the net income divided by the weighted average number of shares of common stock outstanding during the period. Earnings-per-share are widely cited and disclosed by investors analysts and the media as a barometer of financial performance. There are two earnings-per-share figures basic and diluted.

Basic earnings-per-share include only the shares of common stock that are currently issued outstanding. Diluted earnings-per-share, watched closely by investors and Wall Street analysts, try to capture the estimated impact of not only stock options but any other securities the company has that might become shares of stock in the future.

4 key questions

  1. Is the company profitable or not? –  Obviously we can draw black-and-white conclusions from the bottom line since you might expect some firms to report losses like startups or biotechnology firms still performing research and development.
  2. What is the company’s gross margin and how does it compare to both the operating income or loss and that bottom line? – We need to be sensitive to how gross margins and even operating income and evaporate quickly with high expenses as we move down the income statement.
  3. How do the results compared to the prior period?  Are they improving getting worse? – We always wander what will happen in the future, and the information is there. It’s up to us to use it and understand it in its proper context.
  4. The reported results show any consistent trends? – Because we are generally evaluating historical financial results and accounting disclosures to predict the future is important to get a sense of how consistent pass results have been

The Income Statement Matters

There is no question that the income statement is the financial statement that gets the most attention from and with good reason, it provides a lot of critical accounting and financial information to investors creditors and management alike:

  1. we need to understand its general structure from top line revenues to the bottom line net income and the various subtotals in between namely gross margin operating income and earnings before taxes.
  2. reported income or loss can differ significantly from actual cash flows thanks to accrual accounting.
  3. knowing how to compute the gross margin percentage and EBIT are two things all investors and business people should have in their toolkits.
  4. the next time you are reading or watching the business news and they are discussing earnings-per-share which happens very routinely throughout certain times of the year you will know where to find this very important metric.
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