Last week, I tried, somewhat successfully, to give you guys the basics on what a balance sheet is, in an entertaining way. I’m not sure I succeeded in the funny, but you did walk away from that post a little more informed on balance sheets, assuming you could keep your eyes open the whole time. Today, we look at the income statement, the financial report that lets us know just how much money a company is making.
The Income Statement
Think of the income statement like your budget. Like any budget, it summarizes income (that’s revenue in accounting talk) and expenses (that’s expenses in account- you know what, never mind). Just like the balance sheet, this summary can either be quarterly or annual.
Starting off at the top is gross revenue or total revenue. After that, the company lists the cost of sales. These are all the expenses that are directly related to the cost to manufacture and sell a product. It includes costs of manufacturing facilities, wages for sales staff and factory workers. If you subtract total revenue from the costs of doing business, you get gross income.
After that, there’s certain expenses to every business needs to survive. These are referred to as selling, general and administrative expenses. These are things like middle management, advertising, office expenses and research and development costs. An easy way for companies to increase earnings is just to decrease these expenses.
Once you subtract SG&A expenses from gross income, you get net operating income. Essentially, this number is useless. You’ll see why soon.
Gotta Factor In Interest And Taxes
I lied. The operating income on an income statement isn’t entirely useless. It’s the amount of money a company would make if they didn’t have to pay interest and taxes. Some investors use it because they think it represents a more reliable look at profitability than net income.
After operating income, an investor has to subtract interest costs and the cost of taxes to get net income. Sometimes, there are special expenses or extraordinary items that come up every now and again, that affect earnings. These special items could include a business writing down the value of certain assets on the balance sheet, or the costs associated with closing down a part of the business.
Once you subtract taxes, interest and any special expenses, you get net earnings or net income. This is the number you’ll hear reported on business TV. Usually, they’ll break it down into a per share number. This helps everyone with certain financial ratios we’ll look at later.
Now that you have a general idea about the items of the income statement, let’s move onto what you can get from it.
Information Garnered From The Income Statement
Even a newbie investor has heard of the price earnings ratio. In case you’re one of the nine people on the whole planet who hasn’t, let me explain to you.
If a company has a share price of $10, and has earnings per share of $10. It has a price earnings ratio of 10 (10 divided by 1). Or, we could say that the company trades for 10 times earnings. If a company can maintain their earnings for 10 years, they’ll earn back their entire $10 share price. If you buy that company, you’re buying a company that earns enough to give itself a 10% return.
If the company earned $0.50 per share, they’d have a p/e ratio of 20. Or, if they earned $2 per share, the p/e ratio would drop to 5. If all things are the same, you want to buy the company with the lowest p/e ratio, since that company is generating the highest return.
Of course, things aren’t always that simple. Often, a company will get penalized with a low p/e ratio because investors don’t like the growth prospects of the company. High growth companies will trade at extremely high p/e ratios if investors are excited enough about future growth.
Another thing an investor can do with the income statement is look at profit margins. If an imaginary company sells $100 worth of widgets and they use $50 to make the widgets. This means the gross profit is $50 per $100 in sales. If we divide 50 into 100, we get gross margins of 50%.
Let’s say after that, the company has SG&A expenses of $40, for operating income of $10. Dividing 10 into 100, we get net margins of 10%.
Margins must be compared to competitors to be a truly effective measure to look at. If company B sells $1000 worth of widgets and makes $50 operating income, their net margins are only 5%. Thus, company A is doing a better job making widgets.
It’s the same thing with p/e ratios. Two cigarette companies will probably have two fairly close p/e ratios. These p/e ratios will probably be pretty low, since cigarettes are a pretty crummy growth business. Comparing their p/e ratios to high growth darlings like Apple or Amazon won’t tell an investor anything.
One More Thing
Investors can take a look at SG&A expenses to see how efficiently a company is operating. Predicting layoffs can be remarkably simple after just a few minutes analyzing expenses. Just one note though, high research and development costs can actually be positive for a company, since this should translate into new products coming down the pipeline. Either that, or I don’t know squat. This is a legitimate criticism.
Stay tuned next week for the cash flow statement. If you have any questions, feel free to share them in the comments.