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Explanation of the Income Statement

By: , dated January 25th, 2013

The income statement (sometimes called the profit-and-loss statement or P&L) is the first financial statement that you’ll find in the annual report. It shows the revenue, expenses and profit for the company during the past year. You can use the income statement to figure out cash flow, profit margins, and other financial metrics for the business. Most importantly, though, the income statement contains the proverbial bottom line: profits.

You should be careful when looking at the income statement since companies can sometimes engage in gymnastics with their accounting methods. The statements are audited by outside firms, however, so there should be footnotes or other markers whenever anything deviates from standard accounting practices. The following list will teach you how to read an income statement and use the information from them to make some simple calculations regarding the firm’s operations.

  • Revenues: The revenue section will tell you how much money the company took in for a specified period of time. Sometimes companies will break down revenues according to business sector or geographic region, but usually there will just be one number. Some companies, especially retailers and manufacturers, use the term sales instead of revenues, but it’s the same idea.
  • Expenses: The expense section will show you how the company spent its money. Companies spend their money on a lot of different activities, so this section is usually broken down into specific sub-sections. You might see expenses such as the following:
    • Cost of Sales: This number includes expenses directly associated with creating revenue, such as labor and materials.
    • Operating Expenses: This number includes activities such as marketing, research and development, and administration. It usually also includes depreciation expenses and any special non-recurring charges.
    • Interest Expenses: This figure includes all the interest the company paid out on its bonds (if any) and/or long-term debt.
    • Taxes: The amount of money paid in taxes by the firm.
    • Extraordinary Expenses: This figure shows any unusual or one-time charges that the firm must pay (e.g. a lawsuit settlement).
  • Profit: The profit section of the income report is the part to which investors pay the most attention. It shows whether the company made money or lost money. It usually includes these specific sections:
    • Net Income: This is the company’s bottom-line profit after all expenses and revenues have been accounted for. If this number is positive, then the company turned a profit for the period. If it’s negative, then the company suffered a loss.
    • Number of Shares: This is the average number of shares outstanding during the specified time period; it is used primarily in order to calculate earnings per share. Two numbers are usually reported here: basic shares and diluted shares. Basic shares include only actual shares of stock outstanding, whereas diluted shares include any securities that could possibly turn into stock (such as convertible bonds or stock options).
    • Earnings Per Share: This number is calculated by taking netincome and dividing by the number of shares (both basic and diluted, so there are two earnings per share figures).
  • Margins: You can find out how much a company is really earning from its revenues on the income sheet by calculating its margins, which are earnings expressed as a percentage of sales. Here are a few margins that you might find useful:
    • Gross Margins will tell you how much a company earns taking into consideration the costs that it incurs for producing its products and/or services. In other words, gross margin is equal to gross income divided by net sales, and is expressed as a percentage. Gross margin is a good indication of how profitable a company is at the most fundamental level. Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing.
    • Net Margins are similar to gross margins, except they take into account all of the expenses associated with the business, including marketing expenses, administrative expenses, etc. (so it is equal to net income divided by net sales). Net margins provide an overall picture for the company; this is what shareholders and investors usually watch most carefully. Low (or negative) net margins might indicate that the company is struggling or is in a competitive industry in which it doesn’t have very much power to dictate its prices.
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