How to Read an Income Statement: Tips for Investors
The financial statement published by a corporation show what a company looked like at one point in time in the past. Financial statements are often made available monthly, quarterly, or annually so the changes from statement to statement show trends that investors can use to determine profitability of a firm. Taking into account the past, present, and future profitability of a firm, investors make investment decisions.
The Income Statement
The Income Statement shows the income, expenses, and any profit or loss from normal operations of a firm. The net income or profit of a corporation is simply the difference between the total revenue of a firm and the firm’s total cost over the specified period of time.
The first items on an income statement are usually net sales and cost of goods sold. Net sales is the revenue generated from operations and the cost of goods sold is the costs directly associated with the sale of the goods and services offered by the firm. Net sales minus cost of goods sold gives gross profit. This figure is important because it indicates the efficiency with which the product of company was sold in the market.
Other expenses such as selling and administrative costs are further subtracted from gross profit to arrive at the operating profit figure. Trends in operating profit from period to period indicate to investors the growth the company enjoyed from the decisions made by its managers. Often a company has other income not directly acquired from its normal operations such as the sale of shares of stock in another company, the refinancing of debt, or even a change in accounting procedures. Added to operating income, a figure called Earnings Before Interest and Taxes (EBIT) is discovered. EBIT represents one of the most important financial figures in a company’s financial statements.
Earnings Before Interest and Taxes (EBIT)
EBIT is an often-cited figure for comparing both intra- and inter-corporation profitability. The importance is in the profit before figuring in the interest and taxes of the firm. Interest is tied to the debt capitalization of a company. Companies with more equity capitalization than debt will naturally have lower interest expense. Also, since the U.S. Government imposes a progressive tax structure on income, the more a company makes the more that is paid in taxes. By removing interest and taxes from a firm’s profitability, the decisions made by the firm’s managers are not penalized because of capitalization structures or by the firm occupying a higher tax bracket than other companies. This figure is also immune to changes in capitalization decisions from period to period and any shifts from one tax bracket to another as the company grows or shrinks.
After Interest and taxes are subtracted from EBIT, a final net income figure is available. Some stock in a company is preferred meaning that there is an obligation to pay these stock holders before the common stock holders. Subtracting this figure from net income gives the net income available for common stock. Dividends paid to stockholders are removed from this figure to arrive at the final figure typically found on the income statement, addition to retained earnings. Retained earnings are those monies available for reinvestment in the firm’s operations or in other securities such as the stock of another company. From retained earnings, several important figures such as earnings per share of stock outstanding and dividends per share are calculated as indicators of a corporation’s profitability.
The income statement is nothing more than a simple accounting of a corporation’s income, expenses, and any profits or losses for the period of time in question. Often published quarterly and annually, the income statement is an investor’s first glimpse of the income generated by a firm from its normal operations. Comparing income statements from period to period gives investors a clearer picture of trends of profitability or losses due to the decisions of the firm’s managers. Significant changes in income can be viewed on the income statement to determine to what the increase or decrease in income can be attributed.
This post is part of the series: Financial Statement Basics
Investors who are successful are experts at accurately valuing a firm. The first step in this valuation is taking a look at a prospective firm’s financial statements to determine its profitability potential. To do this, at least a basic, working knowledge of accounting and finance is necessary.