Introduction to Financial Statement Analysis: Income Statement

In last week’s post, we had a brief discussion about the components and utility of the balance sheet: the piece of financial statement that directly reflects the status of a company at points in time. However, a balance sheet is certainly not the whole picture. We are interested in how the numbers on a balance sheet changes with time. An income statement records parts of these changes in numbers. It provides the details on a company’s sales and expenses through a period of time and by analyzing such information, we can know more about how efficiently a company’s operating.



Above is an example of an income statement. Before we delve into the different categories on the income statement, we should notice that the title says “For the Five Months Ended May 31st, 2014.” This gives us an time interval of which the income statement records the business activities of the company on.

There are multiple ways to dissect an income statement and study the specific entries in groups. I like to cut an income statement into to parts by sales and non-operating or other. Sales represents the business operations about the product or service that a company provides, for example electronic apparatuses are the products that Apple provides. Non-operating or other represents the expenses or gains outside the process of a company’s sale of its product.

Let’s start with sales category. On the very top of the sheet stands revenues, the total earnings of a company’s sale of its product or service through a period of time. For the example above, it would be a 100,000 dollars total earning from January 1st 2014 to May 31st 2014. From revenues, we first subtract cost of goods sold, that is the total cost of attributed to the production of the goods, such as cost of material, cost of transportation, and employee salaries. The difference of revenue and cost of goods sold yields gross profit.

From gross profit, we then subtract operation expenses. Operation expenses can be separated to two parts: selling expenses and administrative expenses. Selling expenses attribute to the costs spent on advertisements. Administrative expenses attribute to the costs spent on the running of the company. Gross profit minus all of the operation expenses yields operating-income, the pure gains from the sales of a company’s products.

Non-operating and other category records incomes and expenses that don’t relate to the company’s product, the gain and losses in lending and borrowing money or lawsuits. Total non-operating plus total operating-income yields net-income, the most important measure of a company’s profitability. Dividends come from the net income of a company, so for a company’s income-stock holders the net income is definitely an important statistics.

For investors that are interested in the value stocks of a company, net income over revenue is a more critical piece of information. (Wondering what’s the difference between income stocks and value stocks? Click here.) A high ratio of such statistics can mean that a company has a great market share or is even monoployzing the business, because they are able to sell their products or services at a much higher price then their cost of producing them. If there were intense competition in the business, then price of product will drop, net income will decrease, and the ratio will decrease as well. Companies such as Apple, Google, and Intel that provides very unique products has a very high ratio of net income versus revenue.

However, the value of net income versus revenue can also largely be determined by the business model of a company. As I mentioned above, Apple, Google, and Intel have high ratios. All three companies are in the IT industry where intellectual properties determine the quality of a product. Therefore, the cost of production is comparatively low, hence the high income-revenue ratio. For other industries such as airline companies, ratio of net income versus revenue can be very dependent on the time period. The cost of services sold is almost fixed for these companies as the number of flights is fixed in a period, and yet its revenue is highly dependent on the number of passengers it has. Thus, the ratio can vary greatly from quarter to quarters.

The high income-revenue ratio is a big advantage for a company, because the company will have more cash and capital to react to difficult situations. For example, if two companies both suffers a great loss in a scandalous lawsuit, the company with higher income-revenue ratio may still be able to maintain a high quantity of production, but the other might have to reduce output because they can no longer afford their operating expenses and cost of goods.

Overall, the income statement records how well a company is doing over a certain period of time. Comparing different income statements with respective balance sheets we can have a general idea if a company is expanding or shrinking, developing or stagnant.




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