Income Statement Analysis

The table of contents provides an overview of the entire income statement investing lesson, showing you the number and topic of each page of study. It is a great reference to print or keep open as you work your way through reading your first income statement.

You are about to learn how to read an income statement. In the following pages, you'll discover how to calculate important financial ratios, which numbers should matter the most to you, and some things you may want to look for as you research stocks or run your own small business.

This sample income statement from Microsoft shows you the most important categories you're likely to find on any profit and loss.

Revenue, also known as sales, shows the money a business brought in through sources such as selling a product or service. The revenue figure is always the first line on an income statement and is the starting point for calculating profits.

Cost of goods sold (COGS) on the income statement refers to expenses directly related to the manufacturing or distribution of goods or services. If you owned a pizza parlor, your cost of goods sold would include dough, meat, sauce, napkins, and plates.

Gross profit is the total revenue subtracted by the cost of generating that revenue, or cost of goods sold. Gross profit is used to calculate gross margin.

Gross Profit Margin can be calculated by dividing gross profit by total revenue. Gross profit margin tells investors the percentage of revenue that is used in the production process.

By now, you've learned the first three lines of an income statement and should be able to explain to someone what each means and why it is important. Let's look at a few examples to make sure you remember what we've discussed.

Operating expenses arise during the ordinary course of running a business. Operating expense consist of salaries paid to employees, research and development costs, and other charges that must be subtracted from revenue.

R&D, short for research and development, costs can range from nothing to billions of dollars depending upon the type of business. Research and development is listed on the income statement as an operating expense.

Selling, general and administrative expenses, or SGA expenses for short, consist of payroll costs, salaries, commissions, travel expenses, and advertising expenses. SGA expense is recorded as an operating expense on the income statement.

Goodwill and other intangible assets represent a special type of asset that you aren't likely to see anywhere else. If the goodwill becomes impaired, management will announce a write-down and reduce the carrying value on the balance sheet.

Extraordinary and nonrecurring items and events are special types of problems or opportunities that arise in the course of a business. The rules governing how to record them on the income statement are important and you should know the difference between the two.

When analyzing an income statement, you must make an accounting for extraordinary and non-recurring items and events. It is best to leave these one-time events out of the equation, basing your earnings valuation on the predictable income of the business.

Operating income is a measurement of the money a company generated from its own operations. Operating income can be used to guage the general health of the core business or businesses. Operating profit margin is another measurement of management's efficiency. The operating profit margin compares the quality of a company's operations to its competitors.

Interest income and expense reflects the amount companies pay on their debt or earn on their deposit accounts. Interest income and expense is sometimes reported as net on the income statement.

The interest coverage ratio is a measurement of the number of times a company can make its interest payments with its earnings before interest and taxes. Interest coverage is calculated by dividing EBIT by interest expense.

Depreciation and amortization expense is recorded against earnings on the income statement in order to spread the initial purchase price of a fixed asset out over its useful life. Although depreciation expense requires no immediate cash outlay, it should not be added back to a company's profit.

Accumulated depreciation is the write-down of an asset's carrying amount on the balance sheet due to loss of value from usage and age. Accumulated depreciation can best be understood by using a new car as an example.

The straight line depreciation method is the simplest and most commonly used depreciation method. Straight line depreciation is calculated by spreading the cost of an asset out over its useful life.

The sum of the years digits depreciation method is an accelerated depreciation method that assumes an asset loses a greater percentage of its value in the earlier years of its useful life. Sum of the years depreciation charges are calculated by adding up the useful years of an asset.

The double declining balance depreciation method is an accelerated depreciation method that increases the amount of charges taken during the first few years. The double declining balance depreciation method can be helpful when comparing and analyzing an income statement.

Depending on which depreciation method is used, the depreciation charges incurred on the income statement can vary greatly. Comparing depreciation methods can make analyzing companies in asset intensive industries much easier.

Earnings before interest, tax, depreciation and amortization, also known as EBITDA, is commonly mistaken for a measurement of cash flow. EBITDA came into existence during the 1980s during the leveraged buyout craze that swept Wall Street.

Income before tax and income taxes are both reflected on the income statement to show investors the amount of operating profit paid for local, state, and federal taxes. For your reference, here is a list of corporate income tax rates.

Depending upon the amount of voting stock owned, minority interests on the income statement will be recorded using the cost method, the equity method, or the consolidated method.

Unreported or look through earnings are the profits that belong to you that are not paid out in the form of a dividend. An investor should put together a portfolio with the highest possible look through earnings to beat the market. When analyzing an income statement, look through and unreported earnings of cost method minority interests should be added back in the income statement.

Discontinued operations are the businesses a company plans on being engaged in for the foreseeable future. Discontinued operations are businesses a company has discarded, sold, or shut down and does not expect to generate revenue or profit in the future.

GAAP accounting rules give management a large amount of leeway in determining how to report their earnings to shareholders. Accounting changes can be a signal of financial fraud.

Preferred stock is a mix between common stock and a bond. Preferred stock holders receive a guaranteed dividend in exchange for limited capital gains.

Net income applicable to common is the bottom line profit the company reported. Analysts divide the net income applicable to common by the total number of shares outstanding to get the basic eps.

Net profit margin is a ratio comparing net profit after taxes to revenue. Investors can calculate the net profit margin by using the income statement.

Basic earnings per share (Basic EPS) is the profit a company made divided by the shares outstanding. Diluted earnings per share (diluted EPS) factor in possible share dilution from stock options, convertible warrants and preferred stock.

Some companies don't include the possible share dilution from options that are underwater. This occurs when an employee owns options to buy shares at a certain price and due to a sudden drop in stock market value, the option is below the excercise price. Share dilution reduces your ownership percentage in the business.

Share repurchase programs increase ownership and earnings per share by reducing the number of shares outstanding.

Return on Equity, ROE, tells investors how much profit a company earned in comparison to the total amount of shareholder equity on the balance sheet. A high return on equity means a business is more likely to generate cash internally. Return on equity is calculated by dividing net profit by average shareholder equity for the period.

The asset turnover ratio calculates the total sales revenue for every dollar of assets a company owns. To calculate asset turnover, take the total revenue and divide it by the average assets of the period.

Return on Assets (ROA) tells an investor how much profit a company generated for each dollar of assets. Return on assets is calculated by dividing revenue by average assets for the period.

Projecting future earnings when analyzing the income statement is best done by focusing on the past earnings record.

These financial formulas, calculations and ratios can be used when analyzing an income statement.

At this point, you should have the ability to understand the most common entries on the income statement, calculate and compare gross, operating and profit margins, examine depreciation policies and put competitors in the same industry on a comparbale basis, calculate ROE, asset turnover, and ROA, and much more.

Let's examine the Abercrombie & Fitch income statement from several years ago to wrap up everything you've learned.

One time and extraordinary events on the income statement such as the sale of a business unit, real estate, intangible assets, and marketable securities can increase earnings while the core business is actually losing money.