The income statement shows figures such as revenue, earnings, and earnings per share. It shows how much money the company generated (revenue), how much it spent (expenses) and the difference between the two (profit) over a certain period.
The income statement gives investors insight on how well the company’s business is performing i.e., whether the company is making profit or incurring losses. Companies with low expenses relative to revenue – or high profits relative to revenue attract investments as they signal strong fundamentals to investors. Consistent sales growth increases company revenues and is a strong driver of profitability and growth. Valuable revenues are those that continue year in year out, short term increases are less valuable and are likely to get a lower price to earnings multiple for a company.
The two most common expenses are the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A). Cost of goods sold is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company. Costs involved in operating the business are SG&A. This category includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. SG&A also includes depreciation and amortisation.
Companies must include the cost of replacing worn out assets in expenses. Some corporate expenses, such as research and development (R&D) at technology companies, are crucial to future growth and should not be cut, even though doing so may reduce expenses and increase earnings on the income statement. Financial costs, notably taxes and interest payments also need to be carefully looked at.Â
Profits = Revenue – ExpensesÂ
There are several commonly used profit sub-categories that tell investors how a company is performing. Gross profit is calculated as revenue minus cost of sales.
Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing which may enhance future growth prospects. A downward trend in the gross margin rate over time can be a sign of future problems facing a company. Year on increases on cost of goods sold are likely to lower gross profit margins and a company with such a trend may have to pass these costs onto customers in the form of higher prices to maintain profitability. This may have an adverse effect on a company’s competitive position in comparison to its competitors and have an impact on its prospects.
Operating profit represents the profit a company makes from its actual operations and excludes certain expenses and revenues that may not be related to its central operations. High operating margins can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Operating profit also gives investors an opportunity to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures (which are needed to do gross margin analysis). Operating profit is a more reliable measure of profitability as it is harder to manipulate than net earnings.
Net income represents a company’s profit after all expenses, including financial expenses, have been paid. A high profit margin usually means that a company has one or more advantages over its competitors. Companies with high net profit margins have a bigger cushion to protect themselves during a financial crisis or in periods of economic downturns. Companies with low profit margins can find it difficult to survive in a downturn. Companies with profit margins reflecting a competitive advantage are also likely to capitalise by increasing their market share during the hard times – leaving them even better positioned for the future.
The income statement can give a valuable insight to investors about a company. Increasing sales offers the first sign of strong fundamentals. Rising margins indicate increasing efficiency and profitability. It is useful to determine whether a company is performing in line with industry peers and competitors. It is also important to look out for indicators such as changes in revenues, costs of goods sold and SG&A to get a sense of the company’s profit fundamentals.