IN my previous article published Wednesday, March 13, 2013, “Understanding Financial Statements – Part 1” we discussed the Balance Sheet. This week we will take a look at another of the three financial statements which investors may analyse to make investment decisions – The Income Statement.

The Income Statement summarises the company’s revenues and expenses over a specific period and measures the company’s “bottom line” whether it is a Net Profit or Net Loss for said period. For the less experienced investor, we will examine the components of this statement, with the aim to simplifying investment analysis and make it easier to apply it to your own investment choices.

The basic items included on the Income Statement are as follows: Net Sales, Cost of Sales, Gross Income, Selling, General and Administrative Expenses (SG&A), Operating Income, Other Income & Expenses, Pre-tax Income, Taxes, Net Income (after tax). Four measures of profitability are revealed at four critical junctions in a company’s operations – gross, operating, pretax and after-tax.

Starting from the top, Net Sales, also called Revenue or Sales, refer to the value of a company’s sales of goods and services to its customers.

Next in line is Cost of Sales also known as cost of goods, or services sold (COGS). This item factors in direct expenses incurred to produce the finished product. For example, all the raw materials, labour and overhead costs directly tied to the production process.

Gross Income or Profit is the difference between Net Sales and Cost of Goods Sold and represents the resources available to cover all of the company’s other expenses. By dividing the Gross Profit by Revenue, you get the Gross Profit Margin. This is a good measurement of the company’s financial health as it tells you how much money out of each dollar sold is available for salaries, benefits, advertising, expansion, debt reduction, and dividend payments to shareholders. The greater and more stable a company’s gross profit margin, the greater potential there is for positive bottom line (net income) results. However, it is important to note that it is possible for a company with a lower gross profit margin to be more profitable than a company with a higher gross profit margin. For example a company such as Wal-Mart may have lower gross profit margins but instead rely

on significantly higher

sales volumes.

The next section deals with expenses associated with supporting a company’s operation. This includes Marketing Expenses and Selling, General and Administrative Expenses (SG&A). These are deducted from Gross Income to determine Operating Income. Financial analysts generally assume that management exercises a great deal of control over this expense category. The trend of SG&A expenses, as a percentage of sales, may be monitored to detect signs, both positive

and negative, of managerial efficiency.

Depreciation is also deducted from gross profit. Depreciation takes into account the wear and tear on assets, such as machinery, tools and furniture and may be spread over the periods they are used. This process of spreading these costs is called depreciation or amortisation. The “charge” for using these assets during the period is a fraction of the original cost of the assets and unlike other expenses, depreciation is a “non-cash charge”, which means that no money is actually paid at the time in which the expense is incurred.

After the deduction of these expenses we arrive at the Operating Income before interest and income tax expenses. Income at the operating level is often used by financial analysts rather than net income as a measure of profitability.

Next companies must account for interest income and interest expense. This is the money companies make from keeping their cash in interest-bearing savings accounts, money market funds and the like, while interest expense is the money companies paid in interest for money they borrow. This may be expressed as a net figure.

This brings us to Pre-tax Income. Other Special Items or Extraordinary Expenses are also deducted. These are commonly identified as restructuring charges, unusual or non-recurring items and discontinued operations. These write-offs are supposed to be one-time events. Investors need to take these special items into account when making inter-annual profit comparisons because they can distort evaluations.

Finally, income tax, an estimate, or an account that has been created to cover what a company expects to pay, is deducted and you arrive at the bottom line: net profit or net losses (Net profit is also called net income or net earnings). This tells you how much the company actually earned or lost during the accounting period.

By dividing Net Income by Revenue, you will get the Net Profit Margin. The net profit margin tells you how much profit a company makes for every $1 it generates in revenue or sales. While net profit margins vary by industry, generally speaking, the higher a company’s net profit margin compared to its competitors, the better.

Oftentimes, income statements also report earnings per share (or “EPS”). This is calculated by dividing Net Earnings by Number of Shares Outstanding and tells you how much money shareholders would receive if the company decided to distribute all of the net earnings for the period.

Information contained within the Income Statement is critical to calculating several ratios used to evaluate the company’s performance. Return on Equity (ROE) which measures the annual percentage yield on the investment made by the owners is calculated by dividing Net Income by Average Stockholders’ Equity (found on the Balance Sheet). Similarly, the Return on Assets (ROA), calculated by dividing Net Income by Average total assets (taken from Balance Sheet) measures annual percentage yield on the gross investment in the business financed collectively by the owners and the creditors. If the ROE is greater than ROA, the company is exhibiting positive financial leverage in that it is making effective use of debt financing to increase returns to their shareholders.

Creditors, interested in evaluating the safety and liquidity of an investment will be interested in the Times Interest Earned ratio. It is calculated by dividing Income before interest and taxes by Interest Expense and measures the ability of the company to cover the payment of interest to creditors.

When an investor understands the income and expense components of the income statement, he or she can appreciate what makes a company profitable and can ultimately make more informed investment choices.