Understanding the Income Statement


The income statement summarizes an answer to the question “how is the business performing?”  It is called different names ranging from “Consolidated Statement of Income” to “Consolidated Statement of Operations.”   Irrespective of the terminology it always starts with the top line “Revenue” and works down to the bottom line “Net Income.”  A detailed tour of the income statement is in Chapter 2 of the online text.

The most important information in the income statement relate to the revenues recognized under US GAAP and the costs associated with obtaining those revenues.  It also consists of gains and losses arising from other parts of the business that support but need not be essential to the primary operations of the business.  Net Income is then calculated as revenues and gains less expenses and losses.

The sub-components can vary from statement to statement but they usually contain Revenues less Cost of Revenues which is referred to as Gross Margin, less other costs associated with operations which is referred to as “Income from Operations” (or equivalent terminology).  Then US GAAP distinguishes between “Continuing Operations” and “Discontinued Operations” and so reports gains and losses from the latter.  Finally taxes are accounted for to get to Net Income or the bottom line. 

You may ask what happened to expenses associated with financing? 

These are often included in operations and so a good analyst usually recasts an income statement to separately highlight non US GAAP numbers such as “EBIT” or Earnings Before Interest and Taxes, and then step down to “EBT” or Earnings Before Taxes before getting to the bottom line.  Sometimes they further add back non-cash expenses such as Depreciation and Amortizations to arrive at “EBITDA” or Earnings Before Interest, Taxes, Depreciation and Amortizations.

Evaluating the strength of a company with income statement information

You can see how strong a company is performing from the income statement in two ways: by looking at changes in the income statement over time, and by comparing the company to others (e.g. to its competitors). Let’s look at an actual company, 1 800 FLOWERS.COM:

The above has plotted some key fields down to Operating Income.  The company has reported data for two sets of time period:  (3-Months End current quarter versus immediate prior quarter, and 6-months ending current quarter versus the corresponding 6-months for 1-year ago).  This immediately provides an analyst with a rich source of information about current performance because sending flowers has a strong seasonality component attached to it.
The immediate and one year apart comparisons provide insights into how the business is performing controlling for seasonality effects.  Two positives are that Net Revenue and Operating Income are increasing from previous quarter and from current 6-months compared to the same period one year ago.  

However, operating income has benefited significantly from one number that has been added to both sets of figures in the current quarter.  This is “Gain on Sale of Stores” equal to $3.8 million which if adjusted out of operations because it is not a re-occurring source of revenue, flattens significantly both sets of Operating Income comparisons.  This causes a careful analyst to look closer at the cost side of the Income Statement as depicted above and below:

The pie chart (enlarged on a computer screen) makes it easy to spot the change in the composition.  Three broad types of costs are worth looking at.  Those that are related to accrual accounting and depend upon management assumptions such as Depreciation and Amortization, those that relate to the sales cycle such as cost of sales and similar expenses and those that are at management’s discretion such as sales and marketing and research and development.  The pie charts and bar charts let you check at a glance these sub categories.  So for example, depreciation and amortization have declined, which in turn boost net income; Marketing and Sales have increased which suggests there is increased managerial emphasis upon boosting sales revenue and cost of revenues have been creeping up which serve to reduce operating income.
Relative changes such as this let you evaluate the strength of the company’s performance plus provide immediate insights into current management actions.  This company has sold off some stores that generated realized gains, plus they have increased their marketing efforts in an attempt to boost sales.  Sales revenue has increased but in addition costs have increased at the operations level such that if the store gains are adjusted out of operating income business performance has been flat.


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