How To Read An Income Statement

  • Importance of analyzing income statement before making an investment.
  • Example of IBM’s income statement in the past decade.
  • Terms used within the income statement.

Income statement is one of the three major financial statements used by analysts and investors to gauge the performance of a firm. The income statement also known as the profit and loss statement reveals the revenues and expenses of the firm along with the profit earned through them. Having sound knowledge about the important terms helps investors find out if a company is financially sound and whether the firm is hiding something through the income statement.

We can understand the significance of these terms through an actual example. Lets look at the income statement for IBM (NYSE:IBM).

Fiscal year is Jan - Dec. 2014 2013 2012 2011 2010
IBM Revenues 92.79B 99.75B 104.51B 106.92B 99.87B
Cost Of Goods Sold (COGS) 46.39B 51.25B 54.21B 56.78B 53.86B
IBM Gross Profit 46.41B 48.51B 50.3B 50.14B 46.01B
R&D Expense 5.44B 6.23B 6.3B 6.26B 6.03B
SG & A Expense 23.18B 23.5B 23.55B 23.59B 21.84B
Income Before Depreciation Depletion Amortization 17.79B 18.78B 20.44B 20.29B 18.15B
Depreciation Depletion Amortization - - - - -
Non Operating Income 2.68B 1.15B 1.92B 1.13B 1.94B
Interest Expense 484M 402M 459M 411M 368M
IBM Pretax Income 19.99B 19.52B 21.9B 21B 19.72B
Provision for Income Taxes 4.23B 3.04B 5.3B 5.15B 4.89B
Minority Interest - - - - -
Investment Gains Losses - - - - -
Other Income - - - - -
Income Before Extraordinaries & Disc Operations 15.75B 16.48B 16.6B 15.86B 14.83B
Extraordinary Items & Discontinued Operations -3.73B - - - -
IBM Net Income (Profit/Loss) 12.02B 16.48B 16.6B 15.86B 14.83B
Average Shares used to compute Diluted EPS 1.01B 1.1B 1.16B 1.21B 1.29B
Average Shares used to compute Basic EPS 1B 1.09B 1.14B 1.2B 1.27B
Income Before Nonrecurring Items 16.7B 17.96B 17.63B 16.19B 14.83B
Income from Nonrecurring Items -950M -1.48B -1.02B -330.43M -
IBM Earnings Per Share Basic Net 11.97 15.06 14.53 13.25 11.69
IBM Earnings Per Share Diluted Net 11.90 14.94 14.37 13.06 11.52
EPS Diluted Before Nonrecurring Items 16.53 16.28 15.25 13.38 11.52
Preferred Dividends Acc Pd - - - - -
Dividends Common - - - - -
Dividend Per Share Common 4.25 3.70 3.30 2.90 2.50

Source: IBM profit and loss statement

We will look into each item available on the income statement:

Revenue

This is the first item on the income statement or the P&L statement stating the actual sales made by the firm. Although most of the investors actually concentrate on bottom line/profits of the firm it is also important to look at the top line/Revenues to see how the firm is performing. After a business matures it is generally difficult to increase the profit margins beyond a point. The actual growth of profits is possible only through increase in revenues.

In the below chart we can see how the two tech titans fared over the years by looking at their revenue growth. While Google (NASDAQ:GOOG) grew its profits and revenue many folds, Yahoo (NASDAQ:YHOO) has seen a decline in both revenue and profits in the past decade.

Yahoo Vs Google Revenue
Fig 1: Yahoo revenue chart by Amigobulls

Cost of Revenue

Cost of revenue or cost of sales or cost of goods sold (COGS) refers to the cost incurred in production of materials or services. For a service oriented firm like IBM the major cost inputs is labor costs whereas for a manufacturing firm it would be raw materials, manufacturing overhead and labor. In case of retailers like Amazon (NASDAQ:AMZN) or Overstock (NASDAQ:OSTK) it would be the purchasing price of the merchandise.

Gross Profit

Subtracting the cost of revenue from total revenues gives gross profit. This gross profit is the backbone which allows other functions like R&D, sales and administrative expenses. A higher gross profit margin shows that the firm is able to devote more funds to other operating expenses.

Operating expenses: These include all the other expenses involved in operations.

R&D: Research and development expenses made by the firm are categorized here. This is important for technology firms especially as it shows the investments in newer technologies. IBM has devoted a constant 6% of revenues towards R&D expense for the past decade. Most other firms including Microsoft (NASDAQ:MSFT), Amazon, Apple (NASDAQ:AAPL) and Google have specific budgets allocated to this item.

inc1
Fig 2: This figure shows the R&D expense as a percentage of revenue in the past decade. Source: YCharts

The figure is very revealing as it shows that the most innovative firm (Apple) in the world has the lowest percentage allocation to R&D whereas Yahoo has the highest expense. Hence an in-depth analysis of product pipeline is also required besides looking at the raw R&D expense figures.

Selling, General and Administrative Expenses: Also termed as SG&A they show the management’s efficiency in conducting the business. Higher SG&A shows that the firm is spending greater resources on sales and other expenses. This expense is generally viewed along with industry peers to find if the management is using resources judiciously or squandering them on unnecessary expenses. This is extremely important for firms involved in heavy marketing like print and television media. They would need to keep a tight control on the marketing budget and see to it that it is in line with the revenue growth.

ibm-revenue-sga-rd1
Fig 3: Tight control on SG&A expenses by IBM management as the firm's revenue rose. Source: YCharts

Non-recurring expenses: These expenses are incurred due to unforeseen events and are not believed to be required again. They are not part of the firm’s day to day operations.

Operating Income

Subtracting the operating expenses from gross income gives the operating income.

Income from continuing operations: This depicts the actual income earned by the company. It is obtained after subtracting interest and tax expenses. In case there are other income/expenses they are added/subtracted from the operating income.

Earnings Before Interest And Tax or EBIT

Earnings before interest and tax (EBIT) is an important item showing the company’s performance without the additional effect of taxes or interest expenses. Some industries like telecom or utilities might have high debt leverage which can cause high interest expense. This would reduce the final income earned even though the firm might be earning good EBIT. When the interest expense is very high the firm generally tries to bring down their leverage through sales of assets or restructuring of their loans.

Pretax Income

After subtracting the interest expense from EBIT the income before tax for the firm is found. The final tax expenses would be calculated on this figure.

Income tax expense: Income tax expense is calculated based on the corporate taxes required. Multinationals like IBM have the additional advantage of using low tax havens to reduce their tax expenses. The firm’s ability to reduce their effective tax expense affects the final net income drastically. Using EBIT helps in finding the actual increase in income through operations without the effect of the tax expenses which is why it is considered a valuable information source.

Net Income from continuing operations: This figure is obtained after deducting interest expense and tax expense from EBIT.

Non-recurring items: Expenses/income from one-time events is placed in this category.

Discontinued Operations: If a firm sells a part of its business or there are write-offs they will be categorized in this section. Details of these expenses are given in the footnotes. IBM took a huge hit of over $3.6 billion in the third quarter of 2014. This was due to the sale of its chip manufacturing business to Globalfoundaries. This is an important event which needs to be considered as the firm’s net income dropped drastically due to it. As it is a one-time event the significance for the firm is much less and analysts might look at other items like Net income from continuing operations or EBIT to gauge the performance of the firm in that quarter.

Effect of accounting changes: a change in accounting principle or change in depreciation methods will lead to additional income/expense for the firm. These changes are disclosed in the footnotes and are closely analyzed to find if they change the true value of the company.

Net Income

After subtracting the non-recurring events from net income by continuous operations we will get the net income earned by the firm. This is the bottom line which is available to the end investors. There might be events which can affect net income to a great extent like sale of particular units or write offs. At the same time the firm might have a high debt level which can cause a higher payout in interest obligations. Hence analysts look at this term holistically with due importance given to the reasons behind rise or fall in net income.

The below chart shows IBM's net income for a period of 2 years. The bar at in the last quarter is missing due to low net income of $18 million made by IBM. This was due to the sale of discontinued operations and the losses incurred due to it.
IBM Net Income
Fig 4: IBM Net Income Chart by Amigobulls

Preferred Stock And Other Adjustments: This item shows any dividends which have to be paid to the preferred stock owners before the income is available for common shareholders.

Net Income Applicable To Common Shares

This is the final income available to common shareholders. On the basis of this Earnings per share (EPS) is calculated which is a major item showing how well the firm is functioning.

Conclusion

While analyzing the income statement different items are closely watched and also measured against other peers of the industry to find the efficiency of the firm. In case there are extraordinary events or non-recurring events they are factored in to find the ideal market price for the firm’s stock. In IBM’s case the third quarter results shows EPS is $0.02 against EPS of $3.77 in the same quarter of the previous year. However this was due to discontinued operations and hence it’s earnings from continuing operations of $3.46 per share are compared with the previous year’s earning from continuous operations which was $3.77 per share. This decrease of 8 percent was taken as the main performance matrix.

Income statement is a great tool which is released by all the publicly traded firms. It gives a great insight into the performance of the firm and how well it is able to allocate resources to different expenses. The ability to astutely analyze every item should help an investor in separating winners from losers.

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