Understanding the basics of the income statement is the first step to understanding fundamental analysis
The income statement is the financial report that shows investors how sales (top line) and expenses are being turned into net income (bottom line.) The income statement is sometimes called a P&L (Profit and Loss) statement and is one of the three key financial statements released to the public each quarter. The most popular financial metric, earnings, comes from the bottom line of the income statement, which makes this an important report to understand.
Part One: Using the income statement
The income statement typically has three sections.
1. The first section shows total revenue or sales minus the cost of goods sold or cost of sales. The result of this small equation is often called gross profit or gross margin.
2. The second section includes operating expenses such as selling, administration, research and development. Once these expenses are deducted from gross profit the result is known as operating profit or operating margin.
3. In the third section taxes, interest and special charges are deducted from the operating profit and the result is known as net income, earnings or profit.
The income statement will contain several individual line items but they will each fall within one of these three categories. In the image below, you can see these sections in the income statement for Microsoft (MSFT).
The way that a company reports information on the income statement can be somewhat misleading. Here are a few examples of ways that investors can be distracted from the numbers that really matter on the income statement.
1. Revenue does not equal cash inflow. The gross revenue numbers or sales shown on the income statement can understate or overstate the actual cash flow from the company’s marketing efforts. Sometimes the difference it very material and can give a misleading picture of corporate performance.
2. Earnings before interest and income taxes and sometimes depreciation and amortization (EBIT/EBITDA) are sometimes emphasized in an earnings report to make the performance picture look a little better than the actual net income number.
3. Net income does not equal dividends. Just because a company is profitable does not mean they are returning any that income to their owners (shareholders) through dividends. In today’s world of long term flat returns on stock prices, dividends are becoming even more important.
4. There are two ways to increase earnings or net income. Cutting costs will increase net income if sales are flat but it is not sustainable in the long term. Increasing sales numbers can increase net income and is usually a better indicator of growth potential than cutting costs.
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