As an investor, it’s important for you to choose the right stocks and funds for your portfolio. If you’re picking your own investments instead of working with an advisor, then you may want to research the companies you’re considering investing in. While researching a company, there are a few important financial documents that you should check: a company’s income statements, balance sheets and cash flow statements. In this guide, we’ll breakdown what an income statement is.
What Is an Income Statement?
An income statement – also called a profit and loss account or profit and loss statement – is a report that summarizes a company’s revenues and expenses over a specific period of time. It also shows the company’s profit or losses, often as the bottom line of the income statement.
Income statements usually cover one year, but all public companies must submit them to the U.S. Securities and Exchange Commission (SEC) every quarter. This frequency keeps companies honest about their finances and it helps investors who are researching a company.
Why Investors Should Care About Income Statements
When researching a company, you want to know if the company is profitable. Investors use income statements to determine the profitability of a company over time. You can also look for trends in company spending and earnings because the statement breaks down individual revenue and expenses. When a company isn’t profitable or if its profits change from year to year, an income statement lets you see where the money is going.
Another important feature for investors is the information on earnings per share (EPS). This is the amount that a company would pay shareholders, per share, if the company paid out all of its net income as dividends. Companies don’t have to make these payouts, though, and they usually reinvest the money back into the company instead of paying it to shareholders. If a company does pay dividends to shareholders, the income statement will show how much the company paid out.
Reading an Income Statement: Revenue
When looking at an income statement, you’ll see that there are three main sections. At the top is income and revenue information. Then you’ll see a breakdown of the company’s expenses and losses. At the bottom of the statement is net income and usually information about shares, such as EPS.
There are no strict requirements for the exact order of these items on an income statement. Some companies also break down revenues and expenses more thoroughly than others. With that in mind, the following is a look at the common revenue items on an income statement.
This is usually the total, or gross, revenue a company had from the sale of its products or services over the covered period. “Gross” simply indicates that this value has not been modified in any way. It’s the unaltered total revenue. On a simple income statement, this may be the only revenue number. Commonly, it will break down into a few other categories.
This is the company’s revenue minus any money the company didn’t (or doesn’t expect to) receive from its sales. For example, this could include money not earned because of store discounts or the return of merchandise. You may see the term “sales returns and allowances.” A sales return is when a customer returns something for a refund. A sales allowance is when a customer accepts a product with a reduced price due to an issue like a product defect.
The term “net” refers to the fact that this is not the same as the total sales amount. There have been certain deductions made to this amount.
Cost of Sales
Although we’re still in the revenue section, you will see an account of certain expenses that subtract from the net revenue figure. In general, the line after net revenue will show cost of sales – sometimes also referred to as “cost of revenue” or “cost of goods sold” (COGS). This value is the amount of money that the company directly spent in order to produce the goods or services they sold. It does not include operating expenses (such as labor), which are listed in the next section. For instance, a burger restaurant would include the cost of beef in its COGS, though not the wages of its cooks.
Finally, we come to the company’s gross profit. This may also be written as “gross margin.” You can calculate gross profit by subtracting cost of sales from the company’s net revenue. This provides a measure for the company’s operating performance. Naturally, higher profit is more desirable. However, this profit number does not indicate the entire operating profit of the company. You need to consider other types of expenses to arrive at that number.
Reading an Income Statement: Expenses
After listing the revenue and profit of a company, an income statement will list the company’s expenses. Again, the order of these items changes from one company to the next. Not all information is even necessary but you will see some common items.
“Operating expenses” is a general term that could include a number of expenses. Companies may or may not list their operating expenses individually. Some things you may see are:
- Administrative costs – includes the salaries of administrative personnel
- Cost of labor – employee wages or salaries, payroll taxes, employee benefits, insurance, paid time off, 401(k) matches, etc. (may or may not include wages paid to contractors)
- Marketing expenses
- Research and development expenses
Operating expenses differ from costs of sale in that the company cannot directly link these operating expenses to the production of the products it sells.
Depreciation, which you deduct from gross profit, accounts for wear and tear on assets that the company uses over the long term. This includes tangible items such as machinery, furniture or vehicles. To calculate depreciation, a company will spread the cost of an asset over the expected life of the asset. The process of spreading these costs over an asset’s life is amortization. It is common to see this section listed on an income statement as Depreciation/Amortization.
After you deduct operating expenses from gross profit, you arrive at a company’s operating profit. This shows profit before deducting interest and income tax expenses. You may also see the term “income from operations.”
This is how much a company paid in interest for money that it borrowed. So if the company has taken out a loan, the cost of interest on that loan goes in this section. Some income statements will combine interest expenses with interest income, while others will list both values here. Interest income is money that a company earns from lending money to other parties or by keeping cash in interest-bearing savings accounts or similar accounts.
Operating Profit Before Income Tax
This is the company’s profit before deducting the cost of income tax. You calculate it by adding or subtracting interest from the operating profit.
This line item accounts for how much the company paid in income taxes.
Finally, we come to the company’s bottom line. “Net profit” tells you how much the company actually earned (or lost) during the period of this income statement. Net profit is a valuable number for investors because you can see whether or not the company actually made a profit. You will also see the terms “net income” and “net earnings.”
Earnings Per Share
After revenue, expenses and profit figures, you will see information on a company’s earnings per share (EPS). EPS tells you how much money shareholders would receive, per share, if the company decided to pay out all of its net income to its shareholders. Most companies reinvest their net profit, so a positive EPS value doesn’t necessarily mean that you will earn a dividend.
If a company pays a dividend to its shareholders, you will see information about the amount of the dividends per share (DPS).
An income statement is a valuable document for investors. Looking at a company’s income statements can help you determine whether or not it’s worth it for you to invest in that company. One important piece of information on the statement is the company’s net profit over a set amount of time. This is usually one year, but public companies must submit an income statement each quarter to the SEC. You can then understand where that profit number comes from by going over the revenues and expenses that the company lists on its income statements.
Another important number to consider is the earnings per share. This value tells you how much you would earn as a shareholder if the company paid out its profits. It’s more common for a company to reinvest that profit, but this number is a good measuring stick nonetheless.
Tips on Investing
One of the best pieces of advice we can give you about investing is to do your due diligence. Make sure to put in the research for each and every stock, mutual fund or other investment that you purchase. This will help you understand exactly what you’re putting money into. Investing exposes you to the risk of losing your money and thorough research can help you minimize your losses.
If you don’t have investing experience, don’t be afraid to talk with an expert before you do anything. An expert like a financial advisor can help you choose investments and create an investing plan. An advisor can also look at the rest of your finances to create a comprehensive financial plan. If you’re interested in working with a local financial advisor, we recommend using our free financial advisor matching service. It considers your specific financial needs to identify up to three advisors in your area who fit those needs.
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