How To Read an Income Statement

By Kirsteen Mackay

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If you are a stock investor, you’ll want to learn to read an income statement. That’s because it can help you make good decisions and avoid bad ones. Let us show you how.

How To Read an Income Statement

So, what's an income statement? It's one of the key documents issued by a company when they update the market on their latest earnings results. The income statement is also called a profit and loss statement or a statement of earnings. This financial document summarizes a company's revenues and expenses for a specific period, such as a month, a quarter, or a year.

As the income statement shows us a company's profitability over a specific duration, it is a handy document to examine. That's why individual investors seeking more profound insight into a company's financial health should learn how to read an income statement.

Investors find the income statement a handy data point. From it, they can glean a clear picture of a company's profitability and overall financial health. Investors often compare a company's income statement to that of its competitors to build their case on whether it makes a good investment or not.

Company Revenues (Sales)

The first item you'll see on an income statement is usually company revenues (sales). This equates to all the money the company has brought into the business from selling its products or services. When a company talks about its' top line,' it means company revenues (sales) because they appear on the top line of the income statement.

Under Sales, you'll see Cost of Goods Sold (COGS), which accounts for the cost of the products sold during the period the income statement covers. 

Subtracting COGS from Sales results in the company's gross profit (gross income) for the period. Under this, you likely find Selling, General, and Administrative (SG&A) expenses, which include things like HR salaries, marketing expenses, legal fees and insurance.

EBIT (Operating Income)

Next comes EBIT (Earnings Before Interest and Taxes), which is also known as Operating Income or Profit Before Interest and Tax.

There are multiple ways to calculate EBIT depending on the financial information you have gleaned from the income statement. 

EBIT = Revenue – COGS – Operating Expenses

or

EBIT = Gross Profit – Operating Expenses

or

EBIT = Net Income + Interest + Taxes

or

EBIT = EBITDA – Depreciation - Taxes

EBIT is a highly valuable metric that gives the investor an idea of the company's profitability without the complication of tax.

Pre-tax Income (Earnings Before Tax / Pre-tax Earnings)

Pre-tax Income is also referred to as profit before tax (PBT), earnings before tax (EBT) or pre-tax earnings.

Pre-tax Income is similar to EBIT but not the same. Whereas EBIT includes interest income, EBT does not. 

Consolidated Net Income

The company's consolidated net income includes any profit or loss that the parent company has incurred from its subsidiaries. So this won't apply to the net income available to common shareholders, but it shows investors where else the company is making money.

Net Income (Net Profit / Net Earnings)

Net Income, otherwise known as Net Profit, or Net Earnings, is found at the bottom of the income statement and is therefore referred to as the company's 'bottom line.' Net Income is arguably one of the most important metrics for an investor to look at.

Net Income = Revenue - (COGS + Operating Expenses + Interest + Taxes) 

Net income is the company's total profits after all expenses are accounted for.

Earnings Per Share

The Net Income figure is used to calculate a company's earnings per share (EPS). Finance professionals and investors use EPS to gauge a company's financial performance over time.

EPS = (Net Income - Dividends on Preferred Stock) / Average Number of Shares Outstanding

EPS tells us the profit each share of the company's stock represents. Consistently high EPS is positive as it suggests the business generates a good return for investors.

EBITDA (Operating Income)

Finally, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is similar to EBIT but also subtracts depreciation and amortization expenses to give us an idea of how well the company generates cash flow.

EBITDA = Gross Profit – SG&A Expenses (excluding depreciation and amortization)

Additional Income Statement Calculations

Revenue Growth Rate

Investors like seeing a company consistently grow its revenue as it suggests popularity and success.

The revenue growth rate shows us if the company sales are increasing or slowing.

Revenue Growth Rate = Current Revenue / Comparable Period Revenue. 

A high revenue growth rate is positive as it shows sales growth, while a low revenue growth rate could be negative as it shows sales are slowing.

Net Income Margin (Net Profit Margin)

The net income margin, otherwise known as the net profit margin, represents the percentage of each dollar of sales the company retains as profit.

Net Income Margin = Net Income / Revenue

A high net income margin suggests the company is a good investment. It signals that it can afford to keep a large percentage of its sales as profit.

Gross Margin Ratio

The gross margin ratio is a profitability ratio that can help an investor see how much profit a company makes after deducting its cost of goods sold. 

Gross Margin = (Gross Profit / Revenue) * 100

The gross margin tells us the percentage of each dollar of sales a company retains as profit. 

Like the net profit margin, a high gross margin suggests the company is a good investment. 

You should also look at the company's gross margin trend. This shows us how the company's gross margin has changed over time. A company with a consistently high gross margin is generally considered a good investment. That's because it suggests the company can maintain a high level of profitability.

Operating Margin

It's also important to pay attention to the company's operating margin, which is calculated by subtracting its operating expenses from its revenue (which gives us the operating income) and dividing the result by the revenue. 

The operating margin represents the percentage of each dollar of sales the company keeps as profit after considering its operating expenses. A company with a high operating margin is generally seen as a good investment, as it indicates that it can keep a large percentage of its sales as profit even after accounting for its operating expenses.

You should also look at the company's operating margin trend, which shows how the company's operating margin has changed over time. A company with a consistently high operating margin is generally seen as a good investment, as it indicates that it can maintain a high level of profitability even after accounting for its operating expenses.

EPS growth rate

The company's EPS growth rate is another calculation worth making from the data on the income statement. The EPS growth rate tells us how a company's EPS has changed over time.

A high EPS growth rate suggests a good investment, indicating rising profits and a growing share price.

Scrutinizing Expenses

Expenses could include COGS, salaries, rent, and other operating expenses. How a company manages expenditures compared to its revenue gives us an idea of its potential for future or sustained profitability.

Total Expenses = Net Revenue - Net Income.

A company that controls its costs while generating decent revenue is generally considered a good investment.

While overall expenses give us an idea of profitability, scrutinizing the individual components of a company's expenses can reveal red flags or a savvy business model.

As a percentage of its sales, the company's COGS lets us know if it is struggling to maintain profitability or is managing it well.

It's also worth looking at research and development (R&D) expenses. They represent the costs associated with developing new products or technologies and are a significant consideration when it comes to start-ups, particularly in healthcare.

A company with high R&D expenses may be investing in its future growth. Still, it is essential to consider whether these expenses are justified, given the company's current level of revenue and profitability.

Conclusion

While all these financial metrics can provide valuable insights into a company's financial performance, they tell us more when compared to industry peers and when market conditions are considered. For instance, a company in a highly competitive industry may have lower margins than a less competitive industry, even if it is otherwise performing well. 

Additionally, it's important to remember that the income statement is just one piece of the puzzle when evaluating a company's financial health. Investors should also look at the other statements included in a financial report, such as the company's balance sheet and cash flow statement. It's also worth studying the company's management team, industry trends, and economic conditions. 

The balance sheet provides information on the company's assets, liabilities, and equity, while the cash flow statement shows the company's inflows and outflows of cash. By studying these financial statements together, you can better understand the company's financial health and outlook.

As always, it's essential to consider the company's overall financial health and do your due diligence before making any investment decisions.

Why not continue your investing education journey with some of our other informative articles:

How to Find Investment Opportunities

How to Read Financial Statements

How to Read a Balance Sheet

How to Read a Cash Flow Statement

What Do Financial Professionals Look for in a Balance Sheet?

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Topics:
Investing
Value Investing
Growth Investing
Retail investing
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Author: Kirsteen Mackay

This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.

Kirsteen Mackay does not hold any position in the stock(s) and/or financial instrument(s) mentioned in the above article.

Kirsteen Mackay has not been paid to produce this piece by the company or companies mentioned above.

Digitonic Ltd, the owner of ValueTheMarkets.com, does not hold a position or positions in the stock(s) and/or financial instrument(s) mentioned in the above article.

Digitonic Ltd, the owner of ValueTheMarkets.com, has not been paid for the production of this piece by the company or companies mentioned above.

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