Reading an Income Statement

The income statement is your window into a company's profitability. It shows how much money came in, how much went out, and what's left over. [DEFINITION] Income Statement: A financial statement that reports a company's revenues, expenses, and profits over a specific period (quarter or year). ### The Income Statement Structure Think of it as a funnel—money flows in at the top and profit comes out at the bottom: **Revenue (Sales)** — "The Top Line" ↓ minus Cost of Goods Sold (COGS) **= Gross Profit** ↓ minus Operating Expenses **= Operating Income (EBIT)** ↓ minus Interest and Taxes **= Net Income** — "The Bottom Line" [EXAMPLE] Apple's Simplified Income Statement (Billions): | Line Item | Amount | |-----------|--------| | Revenue | $383B | | Cost of Sales | $210B | | Gross Profit | $173B | | Operating Expenses | $55B | | Operating Income | $118B | | Net Income | $97B | ### Key Lines Explained **Revenue (Sales):** The total money earned from selling products or services before any costs are subtracted. **Cost of Goods Sold (COGS):** Direct costs to produce products: materials, manufacturing, labor directly tied to production. **Gross Profit:** Revenue minus COGS. Shows profitability of core products. [FORMULA] Gross Margin = (Gross Profit ÷ Revenue) × 100 **Operating Expenses:** Costs to run the business: salaries, rent, marketing, R&D, administrative costs. **Operating Income (EBIT):** Earnings Before Interest and Taxes. Profit from core business operations. **Net Income:** Final profit after ALL expenses, interest, and taxes. This is what shareholders "own." [TIP] Focus on trends over time. Is revenue growing? Are margins expanding or contracting? One quarter doesn't tell the whole story. ### Profit Margins: The Key Ratios Margins reveal efficiency and pricing power: **Gross Margin** = Gross Profit ÷ Revenue - Shows product profitability - Higher is better - Apple: 45%, Walmart: 25%, Software companies: 70%+ **Operating Margin** = Operating Income ÷ Revenue - Shows operational efficiency - Includes all operating costs - Apple: 31%, Average company: 10-15% **Net Margin** = Net Income ÷ Revenue - Shows overall profitability - What owners actually keep - Apple: 25%, Average company: 5-10% [KEY] Compare margins to competitors and historical trends. A declining margin is a warning sign, even if profits are still growing. ### Red Flags to Watch [WARNING] Watch for these concerning patterns: - Revenue growth but shrinking margins - Gross margin declining (pricing pressure) - Operating expenses growing faster than revenue - "One-time" charges appearing regularly - Large gap between net income and cash flow [EXAMPLE] Company XYZ: - Year 1: Revenue $100M, Net Income $10M (10% margin) - Year 2: Revenue $120M, Net Income $10M (8.3% margin) - Year 3: Revenue $140M, Net Income $9M (6.4% margin) Revenue is growing, but margins are shrinking. The company may be cutting prices to maintain growth—a potentially unsustainable strategy. ### Non-Cash Items Not all expenses involve cash: **Depreciation:** Spreading cost of equipment over its useful life **Amortization:** Similar, but for intangible assets (patents, etc.) **Stock Compensation:** Value of stock given to employees These reduce reported profit but don't reduce cash. This is why cash flow analysis is also important. [EXERCISE] A company has Revenue of $500M, COGS of $300M, and Operating Expenses of $100M. Calculate: 1) Gross Profit, 2) Gross Margin, 3) Operating Income. |ANSWER| 1) Gross Profit = $500M - $300M = $200M. 2) Gross Margin = $200M ÷ $500M = 40%. 3) Operating Income = $200M - $100M = $100M. This company has healthy margins. [SCENARIO] You're comparing two retailers: - Company A: 40% gross margin, 8% net margin - Company B: 25% gross margin, 5% net margin Company A appears more profitable, but consider their business models. A might be a premium brand (high margins, lower volume), while B might be a discount retailer (thin margins, high volume). Both can be good investments—context matters.