Contents
Financial Report Basics
How to Read the Narrative Summary of an Annual Report
How to Read a Balance Sheet
How to Read an Income Statement
How to Read a Cash Flow Statement
How to Assess Profitability
How to Assess Liquidity
How to Assess Solvency
Summary of Formulas in this Guide
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How to Read an Income Statement
The income statement shows a company’s overall financial results, including profits, losses, and expenses, during a particular period. The income statement has four key parts:
- Revenue: Money the company received from sales of its products, goods, or services to its customers—also called sales or gross income
- Cost of goods sold: Costs incurred to make or purchase the goods or services that the company sells to customers—also called cost of sales
- Gross profit: The net difference between sales and cost of sales for a period. If sales are greater than cost of sales, the company has earned a gross profit. Gross profit is calculated before expenses, such as taxes, are taken into account. These profits are also called earnings. Gross profit minus operating expenses, such as utilities and supplies, is called operating income or operating profit.
- Expenses: The amount the company spent on costs related to operating the business. These may include administration, marketing, payroll, and so on
- Net profit: A company’s total revenue minus total expenses—also called net income, net earnings, or the bottom line
A Sample Income Statement
The example below shows the specific line items included on most income statements. The remainder of this section explains all of the line items included in this example.
Revenue
The point at which a company considers its revenue earned, called revenue recognition, can vary greatly between companies. It’s critical that you know how a company recognizes revenue before deciding to buy its stock because manipulative revenue recognition is one of most common ways executives can “window-dress” company earnings. In particular, manipulating revenue recognition can help:
- Inflate the profits a company actually achieves in order to appease investors
- Reduce the revenues a company claims to have made in order to lower its tax burden
Investors tend to favor companies that recognize revenue when they actually get paid in full, not when they close a deal or simply “book” the revenue based on expected future sales. The income statement alone won’t tell you how the company recognizes revenue: look for that information in the notes that accompany the financial statements. If you can’t find it, call the company’s investor relations department and ask them directly.
Cost of Goods Sold (Cost of Sales)
Companies don’t often include a detailed breakdown of cost of goods sold (COGS) in their income statement. Typically, though, the category includes the following costs:
- Raw goods: The cost of buying supplies and raw materials required to make the company’s products or to facilitate offering its services
- Labor: The cost of the workers the company used to produce its products or services (this figure does not include payroll wages paid to the company’s regular staff)
- Inventory: The cost of all products the company has produced but not yet sold
For a company to be profitable, its COGS must be significantly less than its total revenue, as that revenue must cover not only COGS but also the company’s various other expenses as well.
Gross Profit
Gross profit shows the difference between the amount a company paid to manufacture its products and the amount it received for selling those products. Gross profit gives investors a sense of whether a company is selling enough products or services to cover its COGS. But gross profit alone doesn’t indicate definitively whether a company is covering its COGS, as it doesn’t take into account all the company’s expenses. The formula for gross profit is:
revenue (sales) − COGS = gross profit
Generally speaking, investors may be inclined to avoid buying stocks of companies with negative gross profit, as a negative number can signal a lack of demand for the company’s goods or services, problems with product pricing, or other serious issues.
EBITDA
In addition to gross profit, income statements also often include a line item called EBITDA, which stands for earnings before interest, taxes, depreciation, or amortization (the gradual paying off of a liability, such as a mortgage). Investors use EBITDA as a starting point to compare companies because only EBITDA shows the profitability of a company based exclusively on its operations. Even so, EBITDA cannot be considered definitive, as interest, taxes, depreciation, and amortization can dramatically reduce net profits, which matter most.
Expenses
Companies have various types of expenses, each of which typically appears in a specific place on the income statement. For example, operating expenses typically appear as a deduction from the gross profit line on the income statement. The four most common types of expenses are:
Expense |
Description |
Location on Statement |
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Operating |
Administration, advertising, research and development (R&D), royalties, sales, and so on |
Gross profit section |
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Interest |
Interest paid on loans and other debts |
EBITDA section |
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Depreciation |
Depreciation on buildings, equipment, and other property |
Gross profit or EBITDA section |
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Taxes |
Total amount company paid in taxes |
EBITDA section |
Net Profit
The net profit is called the “bottom line” for good reason: it’s typically the last line item on an income statement. It’s also the line item that arguably matters most because it represents whether the company has made money after all expenses have been subtracted from the total amount of revenue. Companies with negative net profit numbers have incurred a loss. Though investors sometimes buy the stocks of companies with no net profits, or with losses, this type of speculation can be risky and is not appropriate for all investors. A more conservative strategy for beginning investors is to invest in companies that have had consistent positive net profits over an extended period of time—five years or more.
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