Thursday, April 22, 2010

The Income Statement

You might want to invest in a company for many reasons. Perhaps it's a leader in the industry. Or its CEO has a great record of turning companies around. Or its products are on the cutting edge of technology. But if the company is not turning a profit, or doesn't show strong potential to become profitable over the medium term, you probably wouldn't want to invest in it.

The income statement tells you if the company is making a profit—that is, whether it has positive or negative net income. (This is why the income statement is also called a profit-and-loss statement.) It shows a company's profitability throughout the year—typically, by presenting monthly, quarterly, and year-to-date summaries of the company's operations. In addition, the income statement tells you how much money the company spends to make that profit—that is, what its profit margins are.

How does an income statement present this profitability picture? It starts with a company's revenues: how much money has come in the door from its operations. Various costs—from the costs of making and storing its goods, to depreciation of plant and equipment, to interest and taxes—are then deducted from the revenues. The bottom line—what's left over—is the net income or profit.

Consider the following income statement for Amalgamated Hat Rack.

Retail sales $ 2,200,000
Corporate sales $ 1,000,000
Total sales revenue $ 3,200,000
Cost of goods sold $ (1,600,000)
Gross profit $ 1,600,000

Operating expenses $ (800,000)
Depreciation expense $ (42,500)
Earnings before interest and taxes $ 757,500

Interest expense $ (110,000)
Earnings before income tax $ 647,500

Income tax $ (300,000)

Net income $ 347,500

The cost of goods sold is what it cost Amalgamated to manufacture the hat racks. It includes raw materials, such as fiberglass, as well as direct labor costs.

By deducting the cost of goods sold from sales revenues, we get a company's gross margin—the roughest estimation of the company's profitability.

Operating expenses include administrative employee salaries, rents, sales and marketing costs, as well as other costs of business not directly attributed to manufacturing a product. The fiberglass for making hat racks would not be included here; the cost of the advertising would.

Depreciation is a way of estimating the "consumption" of an asset over time, or of accounting for the diminishing value of equipment as time goes by. A computer, for example, loses about a third of its value each year. Thus, according to the matching principle, the company would not expense the full value of the computer all in the first year of its purchase, but as it is actually used over a span of three years.

By subtracting operating expenses and depreciation from gross margin, we get operating earnings—often called earnings before interest and taxes, or EBIT.

Interest expense refers to the interest charged on loans a company takes out.

Income tax is levied by the government on corporate income.

The bottom line—in this case, the net income is positive, thus indicating a profit—is what the for-profit company lives for.

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