How to read an income statement in five minutes

The income statement covers a period, such as a quarter or a year, and shows how a company turns sales into profit. It is the first financial statement most investors read, and you do not need accounting training to understand its main lines. This article walks through one from top to bottom with a worked example, and explains what to check.

A worked example

Here is a simplified income statement for a fictional company, in millions.

• Revenue: 1,000
• Cost of goods sold: 600
• Gross profit: 400 (a gross margin of 40%)
• Operating expenses (selling, marketing, research and administration): 250
• Operating income: 150 (an operating margin of 15%)
• Interest expense: 20
• Profit before tax: 130
• Tax at 20%: 26
• Net income: 104 (a net margin of 10.4%)
• Shares outstanding: 50 million
• Earnings per share (EPS): 2.08

Let us go through what each line means.

Revenue

Also called sales or turnover, this is the money the company earned from selling its products or services. Ask whether revenue is growing, how fast, and why. Is growth coming from higher prices, more customers, new products or acquisitions? Growth that comes from buying other companies is different from growth that comes from the existing business, which is called organic growth.

Gross profit and gross margin

Gross profit is revenue minus the direct costs of producing what was sold. Gross margin, which is gross profit divided by revenue, shows how much of each unit of sales is left after production costs. A high and stable gross margin can point to pricing power or an efficient process. A falling one suggests rising costs or pressure on prices.

Operating income and operating margin

Operating income subtracts the costs of running the business, such as salaries, marketing and research, from gross profit. It shows how profitable the core business is before financing and tax. Operating margin allows you to compare efficiency across years and across competitors. Expanding margins usually signal a business that is getting better at converting sales into profit.

Interest, tax and net income

After operating income, the company pays interest on its debt and tax on its profit, leaving net income. Net income is often called the bottom line. Watch the interest line: heavy debt can eat a large share of operating profit. The tax rate matters too, since a low rate in one year may not last.

Earnings per share

EPS is net income divided by the number of shares. It is the basis of the P/E ratio. Pay attention to the share count. If a company issues many new shares, EPS can fall even when profit rises. If it buys back shares, EPS can rise faster than profit. Look for diluted EPS, which includes the effect of options and convertible securities.

EBITDA

You will often see EBITDA, which is earnings before interest, tax, depreciation and amortisation. Adding back depreciation and amortisation to operating income gives a rough measure of operating cash earnings. It is useful for comparing companies, but it ignores the real cost of the equipment that depreciation represents, so do not treat it as the same as cash profit.

Read the trend, not a single year

One period tells you little. Look at five years of revenue, margins and EPS, and ask whether the direction is improving or getting worse. Compare each margin with similar companies. A business with growing revenue but shrinking margins may be paying too much for growth. One with flat revenue but rising margins may be getting more efficient.

Also consider seasonality. Many businesses have a strong quarter, such as retailers around the holidays. Compare a quarter with the same quarter a year earlier, not with the previous quarter.

Check for one-offs

Sales of assets, restructuring charges, impairments and legal settlements can swing net income in a single year. Companies often show adjusted figures that exclude such items. Adjusted numbers can be informative, but be wary if the adjustments are large or recur every year, since a cost that appears repeatedly is part of doing business. Compare reported and adjusted figures, and read the notes that explain the difference.

Quality checks

• Is revenue growth supported by cash? Compare with the cash flow statement.
• Are receivables growing much faster than revenue? That can mean customers are paying slowly, or that sales are being booked aggressively.
• Is stock-based compensation large? It is a real cost, even though it is not paid in cash.
• How concentrated is revenue among a few customers or products?

A simple routine

1. Look at revenue growth over several years.
2. Calculate gross, operating and net margins, and see how they have changed.
3. Check the interest and tax lines.
4. Look at EPS and the share count.
5. Note any unusual items and read the explanations.
6. Compare with competitors.

Common mistakes

• Looking at a single quarter or year.
• Accepting adjusted numbers without reading what was excluded.
• Ignoring the change in share count.
• Comparing margins across very different industries.
• Treating EBITDA as cash flow.

Read the income statement alongside the balance sheet and the cash flow statement. Together they give a far more reliable picture than any one alone.