Income statement analysis can be tricky if you don’t know what to look for.
There are many variations of profit and each of these are useful for analysing different aspects of the company. Furthermore, some profit metrics are more reliable for measuring the financial performance of a company than others.
In this article, I’ll provide a step-by-step walkthrough of the income statement and by the end of the article, you will be able to read and analyse an income statement for any company.
How to read an income statement
- Understand how an income statement works
- Analyse the company’s revenue
- Analyse the company’s cost of sales
- Analyse the company’s gross profit
- Calculate the company’s gross margin
- Analyse the company’s operating profit
- Analyse the company’s net profit
- Make important income statement spot checks
1. How an income statement works
The income statement, or consolidated statement of comprehensive income, shows what the company has made in terms of revenue and how much of that is profit for the company and its shareholders for that reporting period.
Other names include the profit and loss statement, or the P&L.
Below is the top half of an income statement for the given period:
The income statement shows us three columns, the far-right column being the full year audited results, and the other two columns being six months for the period ended for the current year and the previous year in order to compare.
Having the previous year’s full results helps because in this instance we can see that the company is on track at the halfway point to beat last year’s revenue target. We can also compare the growth from the same period last year too.
2. How to analyse revenue
In this section, we’re going to look at analysing sales revenue, often known as total sales or ‘top-line growth’. This is because it is always on the top line on the income statement.
What is revenue?
Revenue is the money earned from sales but before the costs have been taken off. It is the money that comes through the till or the money a company is paid.
For example, if we have a coffee wagon and sell ten coffees for £2.00 and make £20.00 – then £20.00 would be our revenue. We haven’t taken off our costs of the coffee itself to sell to our customers.
We can’t gain too much from analysing revenue but one thing we can look at is year-on-year growth.
If revenues are unstable and lumpy then this will show up in the year-on-year figures. Revenue going down is usually negative as this means the company is selling less product or services or charging less for these products or services.
However, sometimes a company may see revenue decline as a result of focusing on higher-margin revenue rather than low-quality revenues. To do that we can look at the cost of sales.
3. How to analyse cost of sales
Cost of sales, or COS, is useful in looking at companies across a similar sector. It is also known as the cost of goods sold (COGS) In this section we’ll learn what cost of sales is and how to use it.
What is cost of sales?
Cost of sales is everything that is involved directly in the sale. It is what is required in order to make the sale at a basic level.
Cost of sales example
For example, in the case of our coffee wagon, it’s the coffee and milk. In order to sell a coffee, our basic requirements and costs on every sale are going to be the coffee itself and additional products such as milk and the paper cup.
We do require a coffee machine in order to produce the coffee but this is not logged as a cost of sale. It comes further down on the income statement. We don’t need to buy a new coffee machine for every coffee sold but we do need coffee and the other basic materials.
Cost of sales analysis
We can look at cost of sales year-on-year similar to revenue growth. If costs are flat then this can be a good thing if revenue has increased. It means our costs are a lower percentage of our revenue.
If the amount of money in costs spent is flat yet our revenue has decreased it means our costs are costing us more in proportion to our revenue. This is clearly not ideal.
In order to further analyse both revenue and cost of sales we need to look at gross profit.
4. How to analyse gross profit
We can use gross profit as a measure of profitability and gross profit can be used when comparing companies in the same sector to analyse their gross margins.
What is gross profit?
Gross profit uses only the pricing power and the cost of raw materials and so does not include everything else required for the business to function.
Gross profit example
In our coffee wagon example, our gross profit is the revenue we have taken in minus our cost of sales. If every coffee cost us 20p to sell and we sold ten coffees for £2 in our first hour of being open then our gross profit would be £18.
This is because each coffee costs £2 but our cost of sales for each coffee sold is £0.20. Therefore our gross profit on each coffee is £1.80.
Gross profit analysis
Gross profit is an important measure of profit for any business because if a company cannot produce a gross profit then it means its cost of sales are higher than its revenue. Gross profit is also known as net revenue or net sales.
If we sold our coffee for £2 yet our cost of sales was £2.20, then we would make a loss of 20p on every coffee sold! Discuss how to actually analyse this, things to look for and so on.
The higher the gross profit then the better this is for the business. This can be achieved by increasing revenue and also by decreasing cost of sales.
Any significant change in gross profit must be investigated. Here are four reasons why gross profit could change:
- Total revenue could change due to a change in the selling price of products and services
- Total revenue could also change because of changes in the number of products sold or services delivered
- A company may sell more or less of a certain product which has different revenues and costs of sales leading to a change in total revenue
- Cost of sales may change – for example, basic materials may rise which would reduce gross profit
To analyse gross profit further we can look at gross margin.
Download the free ebook now
Enter your email to receive my free “How to Make 6 Figures in Stocks” ebook with everything you need to start investing in UK stocks.
5. How to calculate gross margin
Gross margin is a useful measure of looking at companies in the same sector or industry. In this section, we’ll look at gross margin, how to calculate it, and how it can be used.
What is gross margin?
Gross margin takes into account both the revenues and cost of sales of a company and comes up with a margin of profit that can be used as a comparator.
Gross margin calculation
To calculate the gross margin, we need to take the gross profit and divide this by our revenue, to tell us what percentage of our revenue we are converting to gross profit.
Looking at the income statement at the top of the article, if we take our revenue of 22,388 and minus our cost of sales (13,777) we get 8,561. We then need to divide this amount by 22,338 and this gives us 0.38, which is a gross margin of 38%.
Gross margin example
In our coffee wagon, our ten coffees give us a revenue of £20, and our cost of sales is £2. Therefore, our gross margin on our coffee sales is 90%.
Gross margin analysis
We can use gross margin for companies in the same sector but not to analyse companies from different sectors. This is because a coffee business is a high gross margin business yet a grocery store is a low margin business.
Trying to compare these two businesses is like comparing apples with oranges. Rather, it would be best to use several coffee wagon businesses and compare the gross margins.
Gross margin is only useful to compare when looking at the power of the brand or the efficiency of its purchasing power.
A company that commands a significantly higher gross margin than its competitors is able to do so because it is either charging a higher market price for its products or services or they have a very good arrangement with their suppliers (or both!).
A high gross margin also shows that the company has more to cover for other operating costs. The gross margin should be consistent in a business unless there is a significant reason for the gross margin to change, such as a change in strategy or a change in the company’s business model.
One limitation of gross margin is that it doesn’t factor in operating costs. To do this, we should look at operating profit.
6. How to analyse operating profit
Operating profit is the first serious measure of profitability for the business. In this section, we’ll look at what operating profit is, how to calculate it, and how to analyse it.
What is operating profit?
After gross profit, we need to take away operating expenses such as distribution costs and administrative expenses (also known as SG&A in the USA).
The distribution costs are the money the company needs to pay to get its product in front of its consumers. The administrative expenses consists of all other costs such as rent, running costs, and salaries.
Administrative expenses are costs that are not directly involved in the manufacturing process in this example, and will also include marketing expenses, office costs (telephones, internet), travel etc.
By taking both of these costs away we are left with ‘Operating profit’.
This is a much better comparison than gross margin in sectors because operating profit not only takes into account the cost of sales but the costs of everything required in order to produce a profit once all costs have been included.
Operating profit example
In our coffee wagon example, we would need to take gross profit and deduct all the costs of the business. For example, the coffee wagon, the electricity, administration costs of running the business including marketing spending and petrol would be classed as operating expenses.
Operating profit is the number we are left with after we strip out cost of sales and all other costs of doing business.
Operating profit analysis
To analyse a company’s operating profit we can look at its operating margin. This is a similar calculation to the gross profit margin and we take into account all costs when looking at the operating profit margin.
This metric gives a much clearer picture of a company’s ability to generate profits from its operations.
Many investors confuse operating profit with EBIT (Earnings Before Interest and Taxes). Although they are similar as operating profit does not include interest and taxes, EBIT includes non-operating income and non-operating costs.
Non-operating income is revenue that comes into a company that is not a part of its core business operations.
Non-operating income can include dividends from other investments as well as profit and losses from these investments, as well as other smaller revenue streams such as credit offerings, profits and losses from foreign exchange, and asset write-downs.
If the company does not have any non-operating income or non-operating expenses, then operating profit will equal EBIT.
In my opinion, EBIT is a much cleaner metric to use than operating profit. This is because EBIT includes revenue and costs from the entire business rather than just its core activities.
It also strips out the interest and taxes and gives a view on how good the business is at making profits.
Do not confused EBIT with EBITDA as the latter is relatively less useful. As Warren Buffett said: “Who do management think pays depreciation and amortisation – the Tooth Fairy?”
However, just because a company generates healthy operating profit or EBIT does not mean that they will be profitable…
From operating profit, it is relatively easy to get to net profit / net income. Here is the second half of the income statement:
7. How to analyse net profit
In this section, we’ll look at a company’s “bottom line” which is net profit, or also known as net income. This is because the net profit figure appears on the bottom line of the income statement.
What is net profit?
Net profit, or net income, is the bottom line figure on a balance sheet, that is the final amount left to shareholders of the company after all other costs.
Any financing costs must be taken away from operating profit, before we reach profit before tax.
Financing costs in this instance is debt repayment and this is where the tax shield can come in handy, because a company that finances itself with debt can use those debt repayments and interest expenses against their total taxable profit before tax.
Taking on debt can be riskier, but it prevents shareholder dilution and so debt has been attractive for companies looking to expand (especially in the last decade when interest rates have been at rock bottom).
Finally, after all necessary financing costs and taxation has been deducted, we see the net profit, or the bottom line.
When people talk about the bottom line, this is what they are referring to, net profit after tax. This is the figure that we divide into the amount of shares in issue to achieve earnings per share.
Net profit example
In the example of our coffee wagon, our net profit would be our revenue minus our cost of sales (coffee, milk, plastic cups) to get gross profit, then minus our administrative expenses such as electricity and power, petrol, marketing spend, and then we would further need to deduct any interest payments on any loans that our company had taken out and also the income tax paid to HMRC.
This is one advantage of a company financing itself through debt. A company that leverages itself via debt does not need to issue more equity for capital which dilutes shareholders. Companies can take advantage of the tax shield provided by taking on debt.
Net profit analysis
When analysing net profit we can look at the company’s track record for delivering profits. If the company’s net profit is declining year-on-year this could be a sign of a business in distress. Net profit (or net earnings) is the figure we use to calculate earnings per share (EPS).
If there were any significant gains or fall in net profit in a single year it is worth checking out the figures in more detail to see what caused this.
Perhaps the company sold an asset in that financial year which resulted in a large exceptional gain, or maybe the company sold an asset for a loss or even wrote down the asset in depreciation expenses aggressively. It is always worth checking the depreciation and amortisation policy.
PRO TIP: If a company claims that an exceptional cost affected net profit then always ensure that the cost truly is exceptional. If the same cost keeps occurring every year then it is not an exceptional cost!
Companies will often like to report ‘adjusted net profit’. This is the net profit figure after the company’s management has adjusted the figures – usually for the better.
Always ensure that these adjustments are reasonable and that the company hasn’t disguised a hefty net loss as a nice adjusted net profit.
A further trick is for management to put research and development on the balance sheet as an asset (known as a capitalised cost).
This is a cost of doing business and should affect the bottom line but in one case I have seen a company capitalise “exploration costs” well in excess of its market capitalisation, meaning that the company traded at a large discount to its NAV. B
ut all exploration costs show is that the company dug holes in the ground and have nothing to show for it!
Net profit margin
We can also look at the net profit margin which is a ratio that measures the percentage of profit the company earns compared to the revenue it brings in.
Shareholders (as business owners) should pay attention to this metric. It is also used as a measure of the company’s financial stability as again this can be looked at year-on-year.
To calculate the net profit margin, we need to take the operating profit and minus the interest and taxes.
As well as seeing how well the company converts its revenues intp profits, it’s also a measure of the revenue that is being lost due to costs. If the net profit margin is low or becoming lower, this can suggest that excess costs are harming the company’s profits.
PRO TIP: The more a company changes its expenses the less useful net profit margin becomes as a reliable measure for past performance of the business
However, as net profit margin takes into account interest and taxes, a company that finances itself through debt will see the interest harm the net profit margin.
This does not mean that debt financing is bad, but it is something that should be considered when analysing a company. To get an idea of the debt, we need to look at the balance sheet, and I’ve written an article on how to read a balance sheet.
8. Income statement spot checks
Below are four important spot checks I always make sure to check when analysing a company’s income statement for my investments and trades…
- Can the company benefit from operational gearing? Are the costs fixed or is there a cost per unit?
- Are financing costs eating too much into the profit?
- Is revenue growing year on year?
- Are gross margins rising or falling – if falling why?
- Is profit growing year on year?
- Are there any exceptional items such as an asset sale listed which are giving a false representation of the true profitability of the company?
Wrapping it up
The income statement is the financial performance of the company. It’s important because it shows all aspects of the company in terms of its revenue and how these convert into profits.
However, not all of these profits convert into cash. To analyse that, we need to read the cash flow statement.
When analysing financial statements, all three documents (balance sheet, income statement, statement of cash flows) need to be consulted in order to get an accurate valuation of the company’s financial performance.
Remember, the financial statement is for a fixed period of time and we can get further detail on the company’s financial performance by reading the annual report.