Learn To Read Financial Statements Like A Pro (Part 3— Income Statement)
Financial statements are not tough to read. It is just that they are taught in an extremely boring and complex fashion.
Well, not anymore!
Let me simply them for you.
We will walk through the financial statements of Apple (ticker symbol: AAPL) and learn to read them well.
This article will focus on the Income statement.
Check out the following link for lessons on evaluating:
- the Balance Sheet
- the Cashflow Statement
Let’s start!
Income Statement
The Income statement tells how much money a company made or lost during a year or a quarter.
Note that the Income Statement is also called the Profit & Loss Statement.
How is it different from the Balance Sheet? While the Balance Sheet is a snapshot of the company’s finances at a point in time, the Income statement records this over a given period (such as a financial quarter/ year).
How is it different from a Cashflow Statement? Both Income and cash flow statements record a company’s finances over a given period but their difference arises due to something called Accrual Accounting.
The Income statement reflects revenues when they are earned (not necessarily when cash is received) and expenses when they are incurred (not necessarily when cash is paid).
In other words, companies can record sales (or revenue) of a service/ good when it is provided to the buyer, regardless of when the buyer pays.
As long as there is some certainty in receiving the payment, the company can show this sale in its income statement.
This is starkly different from the cash flow statements that show the actual movement of cash, irrespective of when the revenues are earned or expenses are incurred.
If a company has received no cash after a sale, nothing would be recorded in the Cashflow statement. It is this simple!
Therefore, it is extremely important to look at the Cashflow statement first before the other two financial statements.
Let’s go to Morningstar’s website and find Apple’s (ticket symbol AAPL) Income Statement.
This can be found here.
Let’s learn about each section of the Income statement in detail.
Revenue
This is also called Sales.
It is all the money earned by the company from selling goods or providing services.
Note that revenue is recorded in the Income statement when it is earned, regardless of when payment is received.
Cost of Revenue
This is also termed Cost of Sales/ Cost of Goods Sold (COGS).
This represents the direct costs involved in producing goods or delivering services that have been sold by a company during a particular period.
Such costs include:
- Labor costs
- Cost of raw materials
- Cost involved with manufacturing machinery, and more
Note that it does not include:
- Sales and marketing expenses
- Distribution and shipping expenses
- General and administrative expenses
- Research and development costs
A company showing a trend of increasing revenue and relatively stable or even decreasing COGS points towards a great business.
Gross Operating Profit
This represents the profit a company has made after deducting the Cost of Goods Sold (COGS) from its total revenues.
This is also known as Gross Profit or Gross Margin.
Gross Operating Profit = Total Revenues − COGS
Operating Expenses
These include all costs associated with running the core business operations but exclude the direct costs of producing goods or services.
It further consists of the following:
- Research and Development (R&D) Includes costs associated with the research and development of new products, services, or processes
- Sales, General and Administrative (SG&A) Includes costs associated with selling products or services (sales commissions, advertising, and promotions)
- General and Administrative Includes costs associated with salaries of top executives, legal fees, and office supplies
- Staff Cost Includes cost of salaries, wages, bonuses, benefits, and any associated payroll taxes.
- Depreciation & Amortization These tell how much an asset owned by a company has lost its value over its useful life. Calculating these allows a company to spread the cost of these assets over time to reflect their decreasing value as they wear out. Depreciation applies to Tangible assets such as buildings, equipment, vehicles, and machinery. Amortization applies to intangible assets such as Patents, Copyrights, Trademarks, and Goodwill.
- Other Operating Expenses These can include expenses like restructuring costs, legal costs, losses from asset sales, foreign exchange losses, donations, and more.
The total operating expenses are simply the sum of the above.
Operating Income Before Interest & Taxes
This is an important metric to consider.
It is also called Operating Income or Operating Profit.
Operating Income = Gross Operating Profit − Total Operating Expenses
This represents the profit that a company generates from its core business operations.
It excludes any income not directly related to the core activities of the business, such as interest, taxes, and one-time gains.
Rising Operating Income is a good indicator of a solid business.
It helps you compare the profitability of different companies in the same industry, as it removes the effects of financing and tax environments.
There are two important terms to consider at this point. These are:
- EBIT
- EBITDA
Earnings Before Interest & Taxes (EBIT)
EBIT is the same as Operating Income.
EBIT = Operating Income
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
EBITDA adds back Depreciation and Amortization to EBIT.
It is a measure of a company’s operational performance without considering the costs related to the capital structure, taxes, and capital expenditures.
EBITDA = EBIT + Depreciation + Amortization
It is especially useful in industries with high amounts of fixed assets (that are associated with high Depreciation and Amortization) like manufacturing and telecommunications.
Non-Operating Income
This refers to gains or losses that a company makes from activities that are not related to its core business operations.
This could include income or losses from investments, foreign exchange, sale of assets, or other one-time items.
Income Before Income Taxes
This shows a company’s income before the deduction of income taxes.
The income considered here includes both operating and non-operating income.
Provision for Income Taxes
This represents the amount of income taxes that a company expects to pay on its income before income taxes.
Net Income from Continuing Operations
This reflects the company’s net income generated from ongoing business activities, excluding any income or loss generated from discontinued operations and the effect of income taxes.
Net Income
This represents the company’s total profit or loss after all expenses (including income taxes and non-operating activities).
It is also called Net Profit or Net Earnings.
Net Income is an important indicator of a profitability and company’s financial health.
This is how it is calculated taking an example from Apple’s Income statement figures in 2018.
- Operating Income Before Interest and Taxes ($70,898.00) + Non-Operating Income ($2,005.00) = Income Before Income Taxes ($72,903.00)
- Income Before Income Taxes ($72,903.00) — Provision for Income Taxes ($13,372.00) = Net Income from Continuing Operations ($59,531.00)
Given there are no adjustments for discontinued operations:
- Net Income from Continuing Operations = Net Income = $59,531.00
Net Income Available For Common Shareholders
This represents the residual earnings that are available to the common stockholders after a company has settled all its obligations, including interest expenses, taxes, preferred stock dividends, and any other mandatory charges.
It is the amount of profit that is actually available to the shareholders who hold common shares of a company.
Net Income = Revenues − Expenses − Taxes − Interest
Net Income Available for Common Shareholders = Net Income − Preferred Dividends
In the case of Apple, the Net income is the same as the Net income available for common shareholders.
Earnings Per Share (EPS)
This represents the portion of a company’s profit per unit number of outstanding shares of common stock.
It is an important indicator of a company’s profitability and potential for future growth.
When comparing different companies or a company at different times, a higher EPS is better as the company has higher profits relative to its share price.
Basic EPS
Basic EPS is calculated using the following formula:
Basic EPS = Net Income Available for Common Shareholders/ Number of Common Shares Outstanding
Note that Basic EPS does not factor in the dilutive effect of shares that could be issued by the company.
Diluted EPS
When a company’s stock options, warrants, or restricted stock units (RSU) are exercised, this leads to an increase in the total number of shares outstanding in the market.
Diluted EPS takes this effect into account (the “worst-case” scenario).
Diluted EPS = Net Income Available to Common Shareholders / (Number of Common Shares Outstanding + Potential Dilutive Securities)
That’s everything for this article.
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