How To Read An Income Statement
For a new investor, trying to figure out the best place to grow your money can be tough. Especially, when you don’t know where to begin.
Well, here’s a tip.
Buy shares in a business that is really good at making money!
I know, I know… Easier said than done.
No sweat, though. I’m going to teach you some basic research skills that you can use when picking stocks.
The Value Of Financial Statements
To be a great investor you need to understand the 3 primary financial statements.
The Income Statement
The Balance Sheet
The Cash Flow Statement
If you can decode and draw meaningful conclusions from financial statements you will be able to make better, more informed investment decisions.
This article will breakdown the income statement from top to bottom.
What Yo Will Learn
The purpose of an income statement
Each line item found on the income statement, and
Key metrics derived from the income statement that investors use when evaluating businesses.
A Beginners Guide To Income Statements
What Is an Income Statement
In a word, the income statement measures a company’s profitability.
Sometimes, the income statement is also known as a “Profit & Loss Statement” or “P&L” since it lists the total amount of money made as well as the expenses paid to operate the business.
In official documentation, the income statement may also be called the “Consolidated Statements of Operations” or some variation including the word “Operations”. Don’t get confused - It’s all the same thing…
The numbers on the income statement are separated into categories (as you will see below), but there isn’t much detail explaining the itemized transactions that make up each subtotal. So, when you are researching a company it’s helpful to also read the “Notes to Financial Statements”.
The notes are where management explains exactly what is included in each section of the income statement. The notes to financial statements are also where management will give reasons for any significant changes that may have happened since the last quarterly or annual report.
Where To Find Financial Statements
You can find all of the annual reports (10-K) & quarterly reports (10-Q) for US-listed public companies at SEC.gov and SEDAR.com for Canadian-listed public companies.
What Numbers Are On An Income Statement
There are a lot of figures to comb through on the income statement, so let’s go through each one.
Quick note: The major categories on the income statement will be universal from one company to the next. However, if you are comparing two companies and their income statements include slightly different subcategories, check the notes to the financial statements to get clarity.
Gross Revenue (Sales)
The total amount of money made from the sale of goods and services.
This number is at the very top of the income statement so it’s often referred to simply as the “Top Line”. When you hear a business owner mention the Top Line, they are talking about money made before accounting for any expenses.
Cost of Goods Sold
The total cost directly associated with creating the product or service.
This number includes expenses such as the cost of buying raw materials and the cost of labour directly tied to the creation of the finished product.
Gross Profit
Calculated as the difference between the gross revenue and the cost of goods sold, this number represents the money a company makes purely from selling its products and services.
This number also takes into account returns, damaged goods, and discounts.
Gross Profit = Gross Revenue - Cost Of Goods Sold
Selling, General & Administrative (SG&A)
All overhead and operating expenses not directly related to creating the finished product.
This category includes expenses like;
Marketing
Business development, sales, and customer services
Salaries for admin, operations, human resources, IT, and other non-labour staff
Software, computers, office supplies, company phones
Rent, utility bills, property management, cleaning staff etc, etc, etc.
Research & Development (R&D)
R&D involves anything related to creating new products or improving existing products.
Together, R&D and SG&A are known as operating expenses because they are required to keep the business up and running.
R&D tends to be a greater expense for newer companies because new businesses are still trying to innovate and find the best version of their offering. Often, an investment in R&D can lead to improved margins as the company finds more efficient ways to produce its goods. Better yet, R&D can produce patents, higher-quality products, and completely new product lines.
Other Income & Losses
Anything that doesn’t fit into COGS, SG&A, or R&D is generally categorized as “other”.
Other income might include profit realized from the disposition (fancy word for ‘sale’) of assets & equipment or profit generated from a wholly-owned subsidiary company.
Other losses might include writing off damaged equipment or money lost from the exchange of currency.
Generally speaking, “other income & losses” tend to be one-time, non-recurring transactions.
EBITDA
This is a subtotal of how profitable a company before paying interest on loans, tax, depreciation, and amortization.
In order to understand EBITDA best, we need to cover some uncommon terminology.
Depreciation, Amortization & Depletion
Just think, if you buy a car, you can’t expect to recover the full purchase price of that car when you sell it 5 years later. That loss of value over time is “depreciation”.
Physical property and equipment don’t last forever. Since equipment & physical property lose their value over time and eventually become useless, business owners are able to deduct a portion of the property’s value each year. This is the most common way to track the current value of assets that a company owns.
Amortization is an accounting term for the depreciation of intangible assets such as patents.
Believe it or not, putting a patent on a great idea doesn’t protect it forever. Eventually, that patent will expire and there will be a bunch of bootleggers ready to knockoff your product and sell it for half of the price.
For this reason, the value of patents is also amortized over time.
Depletion is the depreciation of land that a company owns for the purposes of extracting raw materials and precious metals.
Once you pull all of the gold out of a mine - It’s worthless. I think you get it by now.
EBIT
Earnings before interest and tax are also known as “Operating Profit” or “Operating Income”. This is how much money a company has available to cover its fixed costs.
EBIT ignores the interest paid on loans and taxes paid on earnings. It can be helpful to compare the EBIT of two similar companies because this number doesn’t account for the capital structure of the business.
Let me explain…
Companies finance their growth via debt and equity (borrowing money and selling ownership share). The mix of a company’s debt & equity is commonly referred to as the company’s “Capital Structure”.
A company that carries too much debt may be a greater risk to investors if the company is not easily able to pay the interest owed on that debt.
EBIT is especially useful when analyzing businesses in capital intensive industries that require lots of expensive property and equipment which is often mortgaged or leased. Ideally, you want to invest in companies that won’t default on their loans at the first sign of trouble.
To see how much a company makes purely from its operations (before taking into account the money they have to pay their lenders) look at EBIT.
EBT
Earnings before tax. By now, this is self-explanatory.
Net Earnings
Ah… Earnings. Possibly, the most heavily scrutinized number in all of finance.
Net Earnings can sometimes be called “Net Income” or “Net Profit”. Technically, this is the money that a company actually makes after all its expenses are paid.
Often earnings are expressed in stock quotes as earnings per share (EPS).
There is much to be said about the utility of earnings as far as investment research is concerned. Many investors, and business executives alike, refute the validity of earnings as a true gauge of organizational success because EPS figures can be heavily influenced by strategic accounting practices and non-cash expenses such as depreciation.
Regardless, the details of that debate are far beyond the scope of this article. All that you need to know is that investors like to see a trend of improving earnings quarter after quarter & year after year.
Profitability Ratios
Data only becomes information when you are able to draw conclusions from it.
Now that you know your way around an income statement, let’s talk about a few key financial ratios that all investors need to pay attention to.
Gross (profit) Margin
Gross Profit / Gross Revenue = Gross Margin
Gross margin is an indication of how much money is kept after paying for whatever it is that the business offers. This number is expressed as a percentage and bigger is always better!
There are a few reasons why you want gross margins to be healthy…
Stability - When a business has strong gross margins there is more room to accommodate an increase in the cost of production. This way, if the cost of raw materials goes up the entire pricing model doesn’t have to be overhauled.
Growth - If two companies sell $1 million worth of goods, but Company A has 90% gross margins (they keep $900,000) and Company B has 10% gross margins (they keep $100,000), who will have more money to reinvest into their business? If you’re investing in growth stocks you want to see healthy gross margins or else the company will be forced to borrow money or give away equity to fund expansion.
Competitive Differentiation - When a market is highly competitive it is harder to justify premium pricing unless your product is significantly differentiated from alternative options. If consumers can’t tell the difference between two items, more often people default to the cheaper of the two. Healthy margins are a sign that a business has a highly desirable product.
Operating Margin
EBIT / Gross Revenue = Operating Margin
Similar to gross margin, operating margin is a profitability metric. The difference is that gross margin is about sales vs COGS whereas operating margin shows us how efficiently a company’s primary business operation makes money.
Operating margin takes into account the COGS, SG&A, R&D, depreciation, and other income.
Improving operating margins is a sign of strong management. It means the business is able to pay less to make each dollar that comes in. This is only possible if management can avoid overspending on excessive marketing, wasteful R&D, bad hires, and the like.
Ideally, operating margins should be steady or increasing year over year.
EPS
Earnings per share is a measure of net earnings compared to the number of shares outstanding.
EPS = Net Earnings - Preferred Dividends / Shares Outstanding
There are actually a couple of different EPS calculations including, “Adjusted EPS” and “Diluted EPS”. Feel free to dive deeper into those on Investopedia.com if you like, but this article won’t get that deep cuz frankly it doesn’t make a big difference.
For many investors, EPS is a critical metric to analyze. However, more important than the actual EPS is the EPS trend.
In the optimal scenario, a company will increase its EPS quarter after quarter and year after year.
Price-To-Earnings Ratio & Earnings Growth Rate
There are different schools of thought when it comes to stock picking. Value investing and growth investing.
Value investors lean towards stocks with a history of strong earnings to ensure that a company is well worth its price. Consequently, value investors love low P/E ratio stocks. Low P/E stocks have a low price relative to their earnings.
Growth investors are in a completely different category. They don’t care if EPS is negative and a company has never made $1 of net income as long as the trend is strong and moving in the right direction. If same-quarter EPS is growing by double-digits year after year (I.e.: Q1 2019 vs Q1 2020), that’s what growth focussed investors like to see.
As you can tell, there’s no magic number that constitutes a “good” EPS.
EPS is just one of many metrics that you can use to paint a bigger picture of a company’s overall financial health.
Final Thoughts On Analyzing Income Statements
I wish I could tell you exactly what profitability threshold separates good investment opportunities from bad ones, but it’s not that easy.
Fundamental Analysis Is Relative
Generally speaking, bigger margins and higher profits are always better when it comes to investments.
But…
Business models vary from one industry to the next, so for the best analysis always compare two companies who are direct competitors in the same niche.
The Trend Is Your Friend
Additionally, it’s a good idea to compare current performance against past performance.
Look back at years past and analyze profitability trends to see if the company is growing or shrinking, speeding up or slowing down.
Keep Investing In Yourself
It may seem like a lot at first, but as you read more financial statements it will all make much more sense.
You won’t become a great investor after reading one article. You won’t become wealthy owning one share.
If you make it a point to keep investing in yourself, though, sooner or later your gains will compound and you will be both wiser and wealthier because of it.