Menu
Menu
Welcome back to our article series on "Financial Statements Analysis". In our previous articles, we explored the significance of financial statements and delved into the intricacies of the Balance Sheet. Now, we are going to look at another very important financial statement - the Income Statement. Also known as the Profit and Loss statement (P&L), the Income Statement sheds light on a company's profitability and financial performance. In this article, we'll take a comprehensive look at the Income Statement, its components, and how it helps investors evaluate a company's earning potential.
The Income Statement is a financial report that showcases a company's financial performance over a specific period, typically a quarter or a year. Its primary purpose is to provide insights into a company's ability to generate profits from its core operations and to assess the impact of expenses on its overall earnings.
Now let’s understand each component of the income statement in more detail. We will use a very simple example for the same. We will look into a real income statement in depth and analyze the same in a separate article (and it will be slightly more technical).
Let’s say you open an ice cream shop. And after 3 months, you decide to prepare an income statement for your business. For simplicity, let’s assume you sell only one type of ice cream. We also assume that you are the owner and there are no employee costs. Then different components of your income statement will look like this:
This represents the total income generated from the sale of goods or services. This item comes at the top of the income statement and that is why it is also called the “Topline” of the business. Let’s say you sold 1000 ice creams for Rs. 10 each. Then your revenue will be 1000*10 which is Rs. 10000.
This includes items like interest or dividends on the investments and gains or losses on the investments. In our case, it is zero. But big institutions hold assets like bank deposits and investments. On this, they generate interest income or gains. If the investment is in loss, then it is marked negatively in the income statement.
The sum of these 2 line items is called the Total Income of the business. Now let’s look at the expenses.
This reflects the direct costs associated with producing goods or providing services. In our case let’s say you bought milk and other ingredients of Rs. 4000 and paid Rs. 2000 in light bill (for making your ice cream) then COGS will become Rs. 6000.
Gross profit is calculated as Revenue minus COGS. And this gives us an idea about the company’s profitability from its primary business operations.
In our case, it is Rs. 10000 - Rs. 6000 = Rs. 4000
This line item encompasses expenses not directly related to production, such as marketing, and administrative costs. Let’s say you printed pamphlets and it cost you Rs. 1000. Then your SG&A is Rs. 1000. This line item also includes the commission paid for the sale of a product or service.
Calculated as Revenue minus core expenses, it reveals the company's profitability from core operations.
In our case,
EBITDA = Rs. 10,000 (sales) - Rs. 6000 (COGS) - Rs. 1000 (SG&A) = Rs. 3000.
This reflects the depreciation of your assets. Let’s say you bought a freezer for storing your ice cream and it cost you Rs. 5000. Then you should not take all the amount as an expense this year as the freezer has a useful life of let’s say 10 years.
So what you can do is divide the cost of Rs. 5000 over these 10 years. This results in the depreciation cost of Rs. 500 in this year. Amortization is nothing but the depreciation of the intangible assets. In our case, it is zero.
It is calculated as Gross Profit minus depreciation and amortization. it indicates the profitability of the company's core operations.
For us,
Operating income = Rs. 3000 - Rs. 1000 = Rs. 2000
Companies need money for various purposes like expansion or working capital needs. For that, they borrow money from institutions or investors using loans or issuing bonds. On that, they have to provide interest. And this is considered an interest expense.
In our case, it is zero, but for most of the listed companies, there will be some interest expense.
This represents the taxes payable on the company's taxable income. Let’s say that our ice cream business falls under the 10% tax bracket. Then our tax expense will be operating income multiplied by the tax rate. And that is Rs. 200.
This is calculated as EBIT minus Interest and Taxes, indicating the company's overall profitability.
In our case PAT = Rs. 2000 - Rs. 200 = Rs. 1800
PAT is found at the bottom of the income statement and that is why it is also called the ‘Bottom Line’ of the business.
Before jumping on to the next part of this article, let’s understand one very important thing. The income statement is calculated on an accrual basis. Now what is the accrual basis? In simple terms, an accrual basis means revenue or expenses are recognized when they are earned or paid and not when actual money changes hands. This means if you sell ice cream to your friend and he tells you that he will pay Rs. 10 next week, then Rs. 10 will be recognized as revenue today and not after 10 days.
And that’s it! Now you know all the key elements of an income statement. Now let’s look at some of the key metrics you can calculate using income statement.
We can calculate the gross profit margin as (Gross Profit / Revenue) * 100. This metric assesses how efficiently the company converts revenue into gross profit.
We can calculate the operating profit margin as (Operating Income / Revenue) * 100. This metric measures the efficiency of the company's core operations.
We can calculate the net profit margin as (Net Income / Revenue) * 100. It indicates the company's overall profitability after all expenses.
EPS is calculated as Net Income divided by the number of outstanding shares. It indicates the portion of earnings available to each shareholder.
In this deep dive into the Income Statement, we explored its components, importance, and the insights it provides into a company's profitability. We hope this article will help you in the fundamental analysis of your potential investments. We will take a real example of the income statement in one of our future articles, and also look at how you sharpely can help you in the fundamental analysis process.