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Course 106
A Tour through the Income Statement

Introduction


When you turn to the financial-statements section of a company's annual report or 10-K form, the masses of numbers can be bewildering and intimidating. But if you know what to look for, these financial statements can be a gold mine of information. In the next three courses, we'll take you on a brief tour through the three major financial statements, focusing on the most important numbers. The income statement is generally the first financial statement you'll encounter in an annual report or SEC filing. It also contains the information you'll most often see mentioned when a company announces its results for a year or a quarter--figures such as revenue, earnings, and earnings per share, or EPS. In essence, an income statement tells you how much money a company brought in (its revenues), how much it spent (its expenses), and the difference between the two (its profit) over a specified period of time--usually a year or a quarter. The exact information presented in an income statement depends partly on the type of business the company is in, and no company's income statement will likely contain all these items. But it is a good idea to be familiar with the most common items you will encounter.

Revenues


The simplest part of the income statement, the revenue section, tells you how much money the company has brought in. Most often there is just a single number for each time period. Larger companies will sometimes break down revenues on the income statement according to business sector, geographic region, or products versus services. Other companies might provide this information in the notes to the financial statements. The revenue number is sometimes called sales, especially for retailers and manufacturers.

Expenses


Cost of Sales. Also known as cost of goods sold, this number represents the expenses most directly involved in creating revenue, such as labor costs, raw materials (for manufacturers), or the wholesale price of goods (for retailers). Large companies that combine manufacturing with services (IBM IBM, for example) will sometimes break down this number into cost of goods sold and cost of services.

Gross Profit. This number is equal to revenues minus cost of sales. It doesn't appear on all income statements, but it can easily be calculated when it doesn't.

Selling, General, and Administrative Expenses (SG&A). This number, also known as operating expenses, includes items such as marketing, administrative salaries, and, sometimes, research and development. These more peripheral expenses are still necessary for the company's everyday operations and are particularly necessary for the company to grow. Sometimes marketing or research and development are broken out as separate line items.

Depreciation and Amortization. When a company buys an asset intended to last a long time, it amortizes the cost of that asset on its income statement; that is, it spreads out the cost over a period of years meant to represent the useful life of the asset (up to 40 years), subtracting part of this cost from its earnings each year. This number is usually included in operating expenses, but only occasionally is it broken out separately on the income statement. It’s always included in the cash-flow statement, though, so you can look there in order to see how much a company’s net income was affected by non-cash charges such as depreciation.

Nonrecurring Charges/Gains. Often, companies will have a one-time charge resulting from a restructuring or an acquisition. Sometimes, they will have a one-time gain resulting from the sale of a subsidiary. Most often, these charges are included with operating expenses, but sometimes they appear further down, after interest expense.

Operating Income. This number is equal to revenues minus cost of sales and all operating expenses. It appears as a separate line item on many, but not all, income statements. Theoretically, it represents the profit the company made from its actual operations, as opposed to such things as interest income and one-time charges. In practice, companies often include nonrecurring expenses (such as write-offs) in figuring operating income, and it is necessary to look closely at the income statement to spot such cases.

Interest Income/Expense. Sometimes interest income and interest expense are listed separately, and sometimes they are combined into net interest income (or expense, as the case may be). In either case, this number represents interest the company has paid on bonds it has issued or received on bonds it owns. Some income statements have a separate line item for income after interest expenses but before taxes.

Taxes. Tax information is usually the last expense listed before net income.

Profit


Net Income. This number represents (at least theoretically) the company's profit after all expenses have been paid, and thus it receives a lot of attention when companies release their quarterly results.

Preferred Dividends. Some companies issue preferred stock, which pays dividends at a specified rate (generally higher than the rate paid on common stock) but has no voting rights. Because preferred-stock dividends are paid before common-stock dividends, they are sometimes broken out as a separate line item after net income, followed by net income available to common shareholders.

Number of Shares (Basic and Diluted). This figure represents the number of shares used in calculating earnings per share; it represents the average number of shares outstanding during the reporting period (a quarter or a year). Basic shares include only actual shares of stock; diluted shares also include securities that could potentially be converted into shares of stock, such as stock options and convertible bonds. For companies that issue a lot of options (such as many technology companies), the number of basic shares can differ substantially from the number of diluted shares.

Earnings per Share (Basic and Diluted). This number, which represents net income divided by number of shares, usually gets the most attention when a company reports its quarterly or annual results. Basic earnings per share (or EPS) uses the basic number of shares for this calculation, and diluted earnings per share uses the diluted number of shares. The distinction is meant to show the effect of stock options, the expense of which otherwise doesn't show up on the income statement; the more options a company has issued, the lower its diluted earnings per share relative to its basic earnings per share. However, just increasing the number of shares only goes part of the way in showing this effect, since many options are very valuable. Thus, companies with a significant number of outstanding options are also required to calculate the fair value of these options, subtract this value from net income, and calculate earnings using this figure. They don't have to show this lower earnings per share figure on the income statement proper, but it can usually be found in the notes.

 

Quiz 106
There is only one correct answer to each question.

1 The profit part of an income statement tells you:
a. The difference between how much a company owns and how much it owes.
b. The difference between how much a company brought in and how much it spent during a given period.
c. The difference between how much a company owns and how much it spent during a given period.
2 "Cost of sales," or "cost of goods sold":
a. Includes the cost of raw materials.
b. Includes items such as marketing and administrative salaries.
c. Includes taxes.
3 Nonrecurring charges:
a. Are included in revenue on most income statements.
b. Are often included among operating expenses.
c. Are the same as taxes.
4 Preferred dividends:
a. Are usually lumped together with taxes in the income statement.
b. Are generally paid at a lower rate than common-stock dividends.
c. Are paid before common-stock dividends and are listed separately in the income statement.
5 What is the major difference between basic and diluted earnings per share?
a. Diluted EPS shows the effect of stock options.
b. Diluted EPS is based on operating income rather than net income.
c. Diluted EPS does not include taxes.
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