What a company produces creates revenues. But to do so inevitably means incurring costs. How can investors sift through financial statements to find a single measure of how the firm’s strategies are translating into profits? For that, we look at the income statement.
The income statement is critical to investors since it can be used to distill the operations of a company, during a particular period, into a single number of earnings per share or EPS. Moreover, the statement of earnings considers revenues for the period and matches them against expenses to leave a snapshot of the company’s profitability for that period. The balance sheet provides a snapshot of financial health at a point in time.
The income statement is generally laid out in a standard format intended to be read from top to bottom. By reviewing each of the five steps, investors can determine the quality and content of the bottom-line figure.
The income statement generally has the following five steps:
1. Gross income
2. Operating income
3. Income before taxes
4. Income after taxes
5. Net income
Sales – Companies account for total finished sales for the period. In other words, there is a low probability that ownership of the goods will not be returned to the company and, as a result, that it will not be paid. Companies typically allow for returned goods in the income statement by reporting net revenues. Within the lesson covering balance sheet items, we discussed the accounts receivable concept. Sales should roughly tally with accounts receivable. Investors want to see sales volumes and revenues increase at a healthy pace over time.
Cost of goods sold – The costs associated with generating sales of finished products are often substantial. Costs may include raw materials, machinery and salaries. When subtracted from the line item for revenues, the result is called gross income or gross profit. This is the first step and shows how profitable the company is BEFORE operating, financial and tax expenses are accounted for.
Operating expenses – There are multiple possible expenses that a company may associate with production that should be subtracted from revenues. They may include advertising, sales and administration costs, depreciation, research and development, payments on leased machinery or repair work. Typically, it is only when research and development costs are substantial will companies list them separately.
Step two involves subtracting operating expenses from gross income to leave operating income. Such income is often referred to as EBIT since it is defined as earnings before interest and taxes for the period and excludes the impact of non-operating costs, extraordinary charges along with interest and tax. The level of operating income explains the efficiency of the organization before accounting for financing or the potential drag from non-operational activities.
Non-operating expenses – Fees and interest associated with outstanding debts owed by the firm are considered interest expense. Because interest is a financial cost, it is classified independently of the operations of the firm.
Any non-operating expenses or profits would be listed after operating expenses, but before tax liabilities. These items might include interest income from investments or gain or loss from the sale of assets. Since they are unrelated to sales activity, these items are monitored independently to measure bottom line impact. By subtracting non-operating expense from operating income, we are left with earnings before taxes or EBT. That is the third income step and considers all revenues and expenses except for possible tax liabilities.
Income tax – Expenses associated with federal and state tax liabilities are listed under income tax expense. While profits are important, companies may attempt to suppress them in order to minimize tax liabilities. By subtracting income tax expense from income before taxes we are left with after-tax income. And for many companies, that is where the income statement concludes as net income. However, for some firms, additional items may be listed as extraordinary items, discontinued operations and any cumulative effect of changes in accounting.
Net income is what investors are typically looking for at the bottom of the income statement. The familiar format, however, is to display earnings per share or EPS, calculated as net income, less preferred dividend payments, divided by the common shares outstanding during the period. Companies with convertible bonds or stocks, stock options or warrants are also required to calculate and report diluted earnings per share on the income statement. This measures the impact on EPS by conversion or exercise of such securities into common stock. A statement of retained earnings is also reported. This may detail the impact on retained earnings displayed in the balance sheet resulting from this period’s earnings and management’s decisions on dividends for the period. Investors hope to see retained earnings grow over time as a result of profitability. Retained earnings is not necessarily a cash item, but may be investments in either current or long-term assets held by the firm.
Conclusion – The multi-step journey from revenues through layers of expenses to arriving at a distilled measure of earnings per share allows investors to measure the effectiveness of management’s strategy. Investors can judge the effectiveness of such strategies over time and this can aid them when judging the benefit of stock ownership. Sales and earnings should grow hand-in-glove over time and investors should be on the lookout to understand how additional sales channels and product introductions impact earnings over time.
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