How to Read the Income Statement
This statement shows how much revenue a company received and the expenses a company incurred during a given period. The difference is the company's profit or loss. The proof of a company's financial strength is earnings power: how much it earns and how consistently it earns. However, investors need to be aware of the myriad of reporting methods used and be wary when methods of calculating revenues and expenses change.
It is important that revenues are increasing. It is also desirable that earnings are growing faster than revenues. Look for operating expense increases below the rate of revenue growth and less contribution to EBITDA and EBIT from non-operating items. Dramatic increases in gross margins, however, may be a red flag for investors. Sales booked significantly before payments are received, excluding promised rebates, presentation of gross revenue figures and booking of non-operating gains, such as gains on over-funded pension funds, should also be reasons for further investigation.
Investors should closely investigate unusual costs - particularly special charges, asset impairments, goodwill impairments, restructuring charges and other write-downs. These items are often classified as unusual as they are deemed to be unrelated to the company's ongoing business. Investors should consider if these items affect future earnings potential. Extraordinary items could be a discontinued operation, a restatement due to a change in accounting policy or some other factor that does not reflect the company's ongoing operations.
Earnings per share, which excludes discontinued operations and is presented net of preferred dividends, is used to calculate the widely watched P/E ratio. A relatively high P/E ratio is an indication that investors feel the company's earnings are likely to grow. Focus on diluted earnings per share. The effect of stock options, warrants, rights, convertible securities and preferred stock are reflected in diluted earnings per share. Over time, comparisons of diluted earnings per share eliminate the variability caused by conversions to common stock.
Income Statement Definitions
After tax adjustments - An expense or credit not expected to be encountered again in the foreseeable future, presented after tax. May include write-off of assets, write-down of assets and provisions for losses.
Amortization - Gradually writing off the value of an intangible asset over a period of time. It is a bookkeeping entry and does not involve the expenditure of cash.
Common dividends - A dividend distributed out of a company's profits or retained earnings to its common shareholders in proportion to the number of shares they hold. Unlike interest on debt, dividends must be voted on by the company's directors before each payment.
Cost of goods sold (COGS) - The total cost of buying raw materials and paying for all the factors that go into producing finished goods or services.
Depletion - Refers to consumption of natural resources which are part of a company's assets. Producing oil, gas, forest products and mining companies deal in products that cannot be replenished and as such are known as wasting assets. The recording of depletion is a bookkeeping entry similar to depreciation and does not involve the expenditure of cash.
Depreciation - Systematic charges against earnings to write off the cost of an asset over its estimated useful life because of wear and tear through use, action of the elements or obsolescence. It is a bookkeeping entry and does not involve the expenditure of cash.
Diluted earnings per share - Earnings before extraordinary items, less preferred share dividends, less interest on convertible bonds, divided by common shares assuming the exercise of securities such as warrants, options and some convertible debt that require the issuance of shares. A measure of potential dilution of earnings per share.
Dividends per share (Dividends per common share) - Dividend paid for the past 12 months divided by the number of common shares outstanding, as reported by a company. The number of shares often is determined by a weighted average of shares outstanding over the reporting term.
Earnings - Profit or loss for a company during a period.
Earnings (before extraordinary items) - Earnings excluding extraordinary gains and losses during indicated fiscal year. Extraordinary items are infrequently occurring transactions or events that, if material, are reported separately from continuing operations.
Earnings per share (EPS) - Earnings before extraordinary items, less preferred-share dividends, divided by average common shares outstanding during indicated fiscal year.
Earnings before interest and taxes (EBIT) - A financial measure defined as revenues less cost of goods sold and selling, general and administrative expenses. In other words, operating and non-operating profit before the deduction of interest and income taxes.
Earnings before interest, taxes, depreciation and amortization (EBITDA) - A financial measure defined as revenues less cost of goods sold and selling, general and administrative expenses. In other words, operating and non-operating profit before the deduction of interest and income taxes. Depreciation and amortization expenses are not included in the costs.
Earning power - Earnings before interest and taxes (EBIT) divided by total assets.
Fully diluted earnings per share - Earnings before extraordinary items divided by common shares assuming the exercise of all securities such as warrants and options, and conversion of all convertible debt and preferred stock.
Gross profit - Sales minus the cost of goods sold.
Gross profit margin - Gross profit divided by net sales, which is equal to each sales dollar left over after paying for the cost of goods sold. Used to measure a firm's operating efficiency and pricing policies in order to determine how competitive the firm is within the industry.
Income statement - A financial statement that lists revenues, expenses and net income during a period of time. Because of the various accounting principles used to record transactions, the dollar values shown on an income statement often can be misleading.
Income tax - A fee charged by a government on income.
Interest - Payment charged by a lender to a borrower for the use of borrowed money.
Minority interest - An item in the balance sheet of the parent company representing the portion of the assets of a consolidated subsidiary considered as accruing to the shares of the subsidiary not owned by the parent. Also, an item deducted in the earnings statement of the parent and representing that portion of the subsidiary's earnings considered as accruing to the subsidiary's shares not owned by the parent.
Net operating margin - The ratio of net operating income to net sales. The amount of each sales dollar left over after all expenses have been paid.
Net sales - Gross sales less returns and allowances, freight out, and cash discounts allowed.
Operating expenses - Expenses incurred in conducting the ordinary major activities of an enterprise, including manufacturing expenses, selling expenses, administrative expenses and the costs of maintenance and repair.
Operating profit (or loss) - Sales minus the cost of goods sold and operating expenses.
Operating profit margin - The ratio of operating profit to net sales. Used to measure a firm's operating efficiency.
Operating revenue - Revenue generated from the ordinary major activities of an enterprise.
Profit/Loss - Revenue and gains minus all expenses and losses for the indicated fiscal period.
Preferred dividends - Payment to holder's of preferred stock at a fixed dividend ahead of the company's common shares and to a stated dollar value per share in the event of liquidation.
Research & development (R & D) expense - Costs incurred in discovering new knowledge about products, processes and services, and then applying that knowledge to create new and improved products, processes and services that fill market needs. Although R&D costs tend to penalize current profits, they eventually benefit the firm's future profits when new products developed as a result of the research become profitable themselves.
Selling and general administration expense - Expenses such as salespersons' salaries and commissions, advertising and promotion, travel and entertainment, office payroll and expenses and executives' salaries.
Total dividend coverage - The extent to which a firm's net income supports the company's total dividend payments. Net income divided by total dividends.
Total revenue - Total revenue from operations, less sales and excise taxes, plus income from investments and any other pre-tax income during an indicated fiscal period.
Weighted average shares outstanding - A rational and systematic method to calculate the average number of shares representative of the fiscal period. Used to calculate earnings per share.
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