There are two main things that I will focus on in this section:
- Main items in an Income Statement
- Caution against drawing conclusions purely from Income Statement
I’ll touch upon the cautionary stance first. We should always see the Earnings along with the sources available to the firm, and that can be seen in the Balance sheet. A firm can be earning $100, but we need to understand what amount of assets is dedicated to generate that income. A firm using $100 to generate $100 is more preferable to a firm using $10,000 to generate the same income. This measure is called the Return on Invested Capital (ROIC). What consists of Invested Capital will be covered when we touch upon the Balance Sheet.
What does the income statement consist of?
A typical income statement will cover the following headings:
| ITEM | WHAT IT REPRESENTS |
| REVENUES | Total value of sales during the period in consideration |
| COST OF GOODS SOLD | Total cost of making the goods, raw material, processing etc |
| GROSS PROFIT | REVENUES – COST OF GOODS SOLD |
| OPERATING EXPENSES: | |
| SELLING, GENERAL & ADMIN | Mostly consist of marketing costs and operational costs in general |
| R&D | Research and development for improving products |
| DEPRECIATION | Entry used to capture the expense of acquiring an asset in the past |
| OPERATING PROFIT | GROSS PROFIT – OPERATING EXPENSES |
| INTEREST EXPENSE | Interest on borrowed capital |
| GAIN/(LOSS) ON SALE OF ASSETS | Profit/loss on sale of existing asset/business line/patents etc |
| OTHERS | Any other non-operating income |
| INCOME BEFORE TAX | OPERATING PROFIT – INTEREST EXPENSE – GAIN/LOSS ON SALE |
| – OTHERS | |
| TAX EXPENSE | Income Tax |
| NET PROFIT | INCOME BEFORE TAX – TAX EXPENSE |
In a nutshell, we need to understand what the company is selling, what are costs of making the product, what are the operating expenses to keep the business running and what are the interest expenses on the money borrowed by company. Taxes are pretty much standard for most of the companies, but some tax subsidies might be applicable for industries that the government wants to promote going forward. Keeping these factors in mind, we will be in a better position to evaluate the underlying business.
In the chapters ahead, I will discuss how to read into these numbers.
Enjoy reading!