INCOME STATEMENT
As we have seen why the financial information is really important for making investment decision , it is time to go through each of the three fundamental statements separately.
Defining income statement would be easier to understand if we refer to economics . Clearly , each company will have revenue but it will also have cost of revenue . Subtracting the latter from the first would give us the profit that the company has accumulated over a specified period of time .
Using income statement is important because it shows how the managers spend the money available. Those managers will always try to maximize profit because otherwise they will not attract investors . (Some of the disposable income that a company has will be accumulated by investors )
There are two ways of measuring income statement report :
| Multi-Step Format | Single-Step Format |
| Net Sales | Net Sales |
| Cost of Sales | Materials and Production |
| Gross Income* | Marketing and Administrative |
| Selling,
General and Administrative Expenses(SG&A) |
Research and Development
Expenses (R&D) |
| Operating Income* | Other Income & Expenses |
| Other Income & Expenses | Pretax Income |
| Pretax Income* | Taxes |
| Taxes | Net Income |
| Net Income (after tax)* | -- |
The only difference between the two is that the single step format does not really measure gross and operating income ; it only measures what is accumulated as income before tax and what is the residual after the tax . Obviously , the multi-step format is going to be more specific that the single-step format . You need to know the operating income because that is one of the main factors of the company. Operating income is everything that is left AFTER taking out operating expenses ( operating expenses is quite broad topic, e.g. it may vary from cost of producing a good to depreciation . Actually , depreciation and amortization is included in operating costs because the company has to sustain e.g.the level of productivity of their machines.) . To put it in another way , operating income is defined by the formula :
Operating income=Gross income-operating costs*
(*Depreciation and amortization are included in operating costs)
Let's look at a sample income statement:
Looking at the gross profit , you can see ever-growing numbers . One more thing that stands out is the 25% increase in the gross profit on the quarter between 30.09.2013 to 31.12.2013 . Obviously , the difference between total revenue and cost of revenue has increased . The cost of production remained somewhat constant relative to the change in the total revenue . So , you can make a conclusion that Facebook must have increased their sales during this period . The annual data looks even more impressive . They actually have increased their revenue almost two folds . But , is that enough ? Does this look convincing ? Let's look at the change in the price of Facebook's share :
We can actually see that during the period between Sep. and Dec. , it opened and closed its price to somewhat the same price . But do you remember that Facebook has increased its sales 25% ? This is going to affect the price of FB's shares the next period. At this point , you will have to read articles about what Facebook's managers are doing inside the it . What is the next innovation going to be ? When is going to be released ? etc.
I tried to find an article about comments on the earnings after 31.12.2013 , to see how analysists interpreted the good numbers and I came up with several , but this one was the most interesting :
In the article the analysist Almario Alexej Alcaraz , who is discussing its development and he is comparing it with its competitors . He is also looking at the P/E ratio and it is important to note something important here. If you see really good numbers , then you should know that growth cannot last forever . Growth itself is dependent on what the managers are doing to SUSTAIN it e.g. for the next quarter . In our example with Facebook , the good earnings of Facebook , made investors invest even more increasing the share price from 45$/share to 67$/share ,which is roughly 30% . Means that if you have invested 1000 dollars on December 2013 , you could have made 300 dollars for four months . You see how important is that you are actually able to read income statement ?
Let's look further to the income statement of Facebook : ( click on it to see more details)
Another important point that I'd like to make is that all those ratios that we were discussing (P/E, EPS , Quick and current ratio ,etc. ) ->these numbers are all derived from those financial statement and income statement is extremely important for calculating them . One clear example is net profit margin .It is defined as a ratio of profitability calculated as net income divided by sales . So , both sales and net income are coming from income statement . There you go - you can actually calculate most of the ratios on the stock screener for each particular company .- isn't that great . You can derive some of the ratios that are not given publicly .
So , these were the points that I want to make , the next post will cover balance sheet - the other important financial statement .
I will be happy to see further questions !Thank you !
Sources used and important links ( look at them , they are really well explained ) :
- http://www.investopedia.com/terms/p/profitmargin.asp
- http://www.investopedia.com/terms/o/operatingincome.asp
- http://www.investopedia.com/walkthrough/corporate-finance/2/financial-statements/income-statement.aspx
- http://www.sec.gov/answers/form10q.htm
Plamen Filipov
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