An income statement is one of the three financial statements made by companies to record its financials. As the name suggests, It is a record of a company’s income (profit or loss) over a period of time, generally a quarter or a year. Hence it is also known as a Profit and Loss or P&L statement. Of the 3 financial statements, income statement is the easiest to read. Many components of an income statement are intuitive and fairly easy to understand. But some may be new if have never seen an income statement. So, let’s begin.
An income statement looks something like this:
As you see, it has multiple line items starting at the top with Revenue or Sales and ending at the bottom with net income. Since revenue or sales are at the top of the income statement, it is known as “topline” and net income is at the bottom, it is known as “bottom line”. Let's start reading it from the top.
Revenue/ Sales:
The sales or revenue shows the amount the company earned by selling its products or services.
More the revenue, the better.
But of course, the revenue does not equal the money the company “earned”. Since the company has to expend some money to provide for these products, we must deduct these “expenses” to find the actual money the company made.
Cost of goods sold:
This is the first expense the company must do to make its products.
It includes the cost associated with making the product itself, such as raw materials, utilities, etc
The lower, the better.
Gross profit:
Remove the cost of goods sold (COGS) from the revenue and what is left is the gross profit.
So, gross profit = Revenue/Sales - COGS
Obviously, the more, the better.
Gross profit helps us calculate the gross profit margin which is an important indicator of a company’s moat.
Gross profit margin:
Gross profit margin = Gross profit / Revenue *100%
A gross profit margin of 40% or more can indicate good financials.
Remember, consistency is key. If a company can continuously stay above this number year after year, the company definitely has a moat and worth your investment.
Operating expenses:
A company doesn’t just have to incur cost of raw materials but also other day-to-day costs to stay operating. These are called the operating expenses. There are several types of operating expenses:
1. SGA (Selling, general and administrative) expenses:
As the name suggests, these includes several administrative costs necessary for daily functioning of the company. Some of the typical SGA costs for a company can be seen below:
2. Research and development (R&D costs):
This is the cost the company spends to research for and develop new products. Generally very high for pharma companies. The lower the R&D, the better. As Warren Buffett suggests, a company that has to spend a lot in R&D is a company that will fail if it is not able to create the next big innovation. That is RISKY.
3. Depreciation:
Whenever a company buys an equipment that it will use for a long time, the cost of that equipment is allowed to be spread over that time period rather than just that one year. This cost every year is depreciation cost.
This has a major benefit. Since companies don’t have to account for newly purchased items/equipments in the year they purchase it, their immediate cost of ownership is reduced drastically.
People often do not look depreciation as minutely as they should while reading the income statement (Often stopping at EBITDA ie. Earnings before interest, taxes and depreciation). But as Charlie Munger says: I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.
Buzzwords like EBITDA are only used by companies that do not have real profits left for themselves.
Operating profit and operating margins:
Remove operating expenses (SGA + R&D + Depreciation) from the gross profit and you are left with operating profits.
Operating profits are also known as EBIT (Earnings before Interest and Tax)
Operating profit margin = Operating profit / Revenue * 100%
Higher the margins, the better. Again, consistency is key.
Compare with peers in the same industry as well as for the company over years. If a company can perform better than its peers, it has better financials.
Other income:
Often the company sells its assets, divests from subsidiaries, may gain or lose due to change in foreign exchange rates.
All this is money that it gains from sources other than sale of products or services hence known as other income. This is added to the income statement.
Interest costs:
Companies often have loans taken for various purposes, the interest for which must be paid each year, much like the EMIs you may pay on your loans.
These are not considered in operating costs, but as financial costs
Lower interest expense means low debt.
Better companies have little to no debt so a very small interest expense is preferred.
Taxes:
After you have paid all the other expenses, the company must pay the money it doesn't want to pay but has to: taxes.
Pro-tip: Always ensure the taxes paid by the company are as per existing corporate tax rates. Any stark difference indicates something is cooking in the financial statements.
Net profit and net profit margins:
Deduct interest and taxes from EBIT or operating profits and you get the net profit of the company. This is the real money the company actually made and shows up at the extreme bottom end of the statement, the 'bottom line'.
Obviously, the more, the better.
Net profit margin = Net profit/Revenue *100%
Compare the net profit margin of a company with its peers in the same segment/sector.
Anything more than 20% in most companies is a very good number. If the company can maintain or increase it consistently, you have found your stock.
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