1. Terminology and formats

There are many different names for income statements: “P&L” (which stands for Profit and Loss), “earnings statement”, “statement of income,” “statement of earnings,” “statement of operations” and “statement of operating results.” All mean the same thing.  Likewise, the terms "profits," "earnings" and "income" all mean the same thing and are used interchangeably.
Two basic formats for the income statement are used in financial reporting presentations - the multi-step and the single-step. These are illustrated in Figure 2 with two simplistic examples:

 

Figure 2 Income statement formats

In the multi-step income statement, four measures of profitability (*) are revealed at four critical junctions in a company's operations:  gross, operating, pretax, and after tax. In the single-step method, the gross and operating income figures are not stated; nevertheless, they can be calculated from the data provided:  gross income is equal to sales minus materials and production; operating income is equal to gross income minus marketing, administrative, and R&D expenses.

Investors must always remember that the income statement recognizes revenues when they are earned (i.e., when goods are shipped or services rendered), not when they are received. Likewise, the income statement recognizes expenses when they are incurred, not when they are paid.  With accrual accounting, the entry of revenue and expense credits and debits on these accounts does not necessarily coincide with the actual receipt and payment of cash. The income statement measures profitability, not cash flow.

 

2. Income statement accounts (Multi-step format)

• Net sales (or net revenue):  Often just called “sales”, this is the monetary value of a business’s sales of goods and services to its customers. While the firm’s net income (its "bottom line") gets most of the attention from investors, the "top line" is where the revenue or income process begins. Also, whereas the bottom line can be manipulated through creative accounting, the top line is captive to reality and hard evidence. Also, in the long run, operational efficiency and thus profit margins on a company’s existing products tend to eventually reach a maximum that is difficult to improve on. Established companies with mature products typically can grow no faster than their revenues.
  
  
• Cost of sales (or cost of goods sold (COGS), and cost of services): Manufacturers use cost of goods sold. It is the expense incurred for all inputs (raw materials, labor, and manufacturing overhead) used in the production of its products. Depreciation expense also belongs in the cost of goods sold, but it may be stated separately. For wholesalers and retailers, the cost of goods sold is what they paid for the goods they have resold.  (The money paid for unsold goods still in inventory is not included in COGS, but in the inventory accounts.)  Service businesses use cost of services rendered or cost of revenues. Most of the cost in cost of services rendered will be allocated overhead.
  
  
• Gross profit (or gross income or gross margin): A business’s gross profit does more than simply represent the difference between net sales and the cost of sales.  Gross profit provides the resource to cover all of the company's other expenses. Obviously, the greater and more stable a company's gross margin, the greater potential there is for positive bottom line (net income) results. Businesses with high gross profits and comparatively low net profits are likely bloated: they are spending too much money on overhead.
  
  
• Selling, general and administrative expenses: Often called SG&A, this account comprises a company's operational expenses. Management exercises a great deal of control over this expense category. Consequently, investors should watch the trend of SG&A expenses, as a percentage of sales, very closely to detect signs of managerial efficiency or inefficiency.
  
  
• Operating income: Operating income is calculated by subtracting SG&A from a company's gross profit. Operating income is a company's earnings from normal operations before any non-operating income and/or costs such as interest expense, taxes and special items. Reported income at the operating level is harder to manipulate, and is thus a more reliable measure of profitability than net income.
  
  
• Interest expense: This is the costs of a company's borrowings. Sometimes companies record a net figure here, subtracting out the interest income from invested funds.  Be sure to look for the explanatory note explaining if this was done, and then break out the two figures (interest paid on borrowed funds vs. interest earned on invested funds) to use in analysis.
  
  
• Pretax income: Earnings before tax is a carefully watched indicator of profitability. There are a vast number of techniques for companies to avoid or minimize taxes that affect their reported income. While it is good to know that a company has excellent tax accountants, the difference they make has nothing to do with a company's business operations or how efficiently they are being managed. Therefore, it is important to use pretax income to more accurately gauge the firm’s efficiency and profitability.
  
  
• Income taxes: As with other items on the income statement, the reported income tax item has not actually been paid – it is an estimate of what a company expects to have to pay.
  
  
• Special items or extraordinary expenses: There are a vast range of unusual events that can result in charges against income. They include fines and lawsuit damages (and awards), restructuring charges, unusual or nonrecurring items, and costs of discontinuing operations (i.e., closing a factory). These write-offs are supposed to be one-time events. Investors need to take these special items into account when comparing changes in profits from year to year because these special items and extraordinary expenses can distort evaluations of the firm’s efficiency and growth. For example, if a firm incurred a huge extraordinary expense two years ago, but had no such expense in the following year, the naïve investor who did not take note of the extraordinary expense would see only a substantial jump in net profit causing him to think it was a good time to invest in that company.
  
  
• Net income (or net profit or net earnings): This is the bottom line, the most commonly used indicator of a company's profitability, because it is out of this account that dividends (if any) to investors will be paid. Lack of net profits in a young, high growth technology company, however, is not a bad thing.  It may even be perceived as a good thing: a sign that management is re-investing surplus revenues in R&D to spur further growth while keeping revenues out of the hands of the taxman.  Investors in such companies are not interested in dividends in the near term, but in the rise of the value of the company’s stock price in the market, which will increase as the young company grows and introduces new and more innovative products.  Investors in such companies act as speculators, hoping to profit from the increased value of their shares.  It is in older, more established companies where investors expect to see a reasonably steady stream of dividends.  Of course, if expenses exceed income, net profit will be negative: the firm will post a loss. After dividends (if any) are paid, the remaining net income becomes part of retained earnings.
  
  
• Comprehensive income: This relatively new (1998) concept, adjusts reported income, taking into account the effect of foreign currency exchange adjustments, minimum pension liability adjustments,  unrealized gains/losses on certain investments, and other such items. These adjustments, however, result from economic and political volatility beyond management’s control, and so give no indication of the company’s long-term profitability. Thus the new investor should treat this category as a special instance of extraordinary expenses.

3. Sample income statement

Now let's take a look at Figure 3, a sample income statement for company XYZ for FY ending 2008 and 2009 (expenses are in parentheses).

 

Figure 3 Sample company income statement

 

From this we can see that between the years 2008 and 2009, Company XYZ increased sales by about 33%, while reducing cost of sales from 23% to 19% of sales. As a result, gross income in 2009 increased significantly. Meanwhile, general operating expenses increased by a modest $25,000. In 2008, operating expenses were 15.7% of sales, while in 2009 they were only 13%. This is extremely favorable given the large sales increase.

Consequently, XYZ’s bottom line increased from $605,000 in 2008 to $885,000 in 2009. The positive trends in all the income statement items, both income and expense, have improved XYZ’s profit margin from 40% to 44%.  XYZ experienced an impressive increase in sales for the period reviewed and was also able to control the expenses. These are indicators of very competent management.

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Language Focus 10.2

Language Focus 2

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Activities

Activity 2