The Numbers Game: How To Read Financial Statements (The Income Statement)

The income statement, also known as the profit and loss statement, is a report on the company's business activities in a given quarter or year. While the balance sheet measures a company's overall health, the income statement measures its performance. It contains two main components: the revenues (money or promises of money flowing in) and the expenses (money or promises of money flowing out).

The first item on most income statement is the revenue, or also sometimes called the top line. When a product or service is sold, the money received or due to receive is called revenue. For start-ups, analysts often consider revenue growth as the most important, rather than earnings. This was a key determinant of stock market value during the internet boom because investors believed revenues showed if a company was gaining market share and customer base. No doubt, revenues are important but it is a mistake to focus just on this top line number. More important, we need to consider the quality of the revenues and the company's entire income statement to gauge its true financial performance.

Under GAAP, there're strict rules for when revenue can be recognized. For example, revenue cannot be counted if the seller must provide a significant amount of services in the future to the buyer. Many companies abused revenue recognition rules in the past.

The next item after revenue is the cost of goods sold, or the amount of paid for the items sold out of inventory - a service company will not have this kind of expense. The income statement also lists other operating expenses such as "selling, general and administrative" costs. This category of expense is important as it measures the efficiency of the management at controlling the overhead costs associated with running its operations.

Another important expense to watch is the cost of research and development. When viewed as a percentage of revenues, R&D expenses can be compared across similar types of companies. If the percentage is unusually high or low, the company may not be managing or investing its R&D dollars wisely. If the percentage is falling, perhaps the company may be cutting its R&D expenses to prop up earnings. It is also important to watch how much of a company's revenue is generated by new products coming out of the R&D pipeline. This provides a good measure of how well the R&D process is being managed.

Gains or losses from discontinued operations and extraordinary gains or losses also appear on the income statement. These extraordinary items must be unrelated to the business normal activities and they must be one-time and highly unusual events. By segregating extraordinary items, one year's income statement can be compared with another's. Another item is restructuring costs. Be careful: many companies have made liberal use of this description for items that are not, in fact, unusual or one-time events.

If a company has determined that one of its operating divisions has experienced lower sales and reduced profitability, it could decide to restructure that division by laying off employees, reducing inventories, and closing plants. Many of the costs associated with this downsizing is called restructuring charges. The expense will be equal to what the management thinks it will incur to pay severance to workers, the other costs, such as ending leases on equipment no longer needed. A restructuring is a signal that the underlying economics of the business have changed - R&D has not been successful in reinvigorating the product line, or revenues are suffering because competitors have gained market share - and can be considered a red flag that the company has long term problems.

The income statement also lists the tax due on the revenues and expenses on the statement. However, this tax figure is only for accounting purposes and may differ from the actual taxes paid, which may cover a different time period and include revenues and expenses not on the statement. Actual taxes owned to the government are determined using arcane rules put out by the Internal Revenue Service. Any difference between taxes based on earnings reported in the income statement and what the company currently owes the IRS is called deferred taxes.

At the end of the in income statement are two important numbers: the net income and earnings per share. Net income, also called the bottom line, is the profit the company shows after subtracting out all expenses and taxes from revenues. This is a GAAP number and differs from so-called pro forma or operating earnings, which are numbers that exclude a lot of noncash charges such as amortization and depreciation, and large expenses such as restructuring costs. Companies go to great extent to pump up their pro forma earnings number - some as far as excluding marketing expenses from the calculation.

While GAAP may not be perfect, at least it forces companies to follow consistent rules for the sake of comparison. Pro forma earnings have to be carefully understood so that investors can see for themselves if the GAAP number of the pro forma number represents the true economics picture of the company. Just be warned: when companies go to great length to exclude all kinds of unwanted charges, the statement for pro forma might as well be called the earnings for everything but the bad stuff.

The other important number at the end of the income statement is the earnings per share (EPS). This number tells how much money the company earned for each share of stock that is outstanding. Again be careful. The better measure of how successful a company has been is the fully diluted EPS number, rather than the basic EPS number. The fully diluted number takes into account stock options issued to managers but not yet exercised. It also includes in bonds, preferred shares, and stock warrants that can be converted to common stock, thus causing a dilution to the basic EPS.

A useful measurement is return on assets (ROA), which also connects the balance sheet to the income statement. Find the net income on the income statement and divide that number by the total assets on the balance sheet. The higher the ROA, the better the management is at using your capital to increase earnings. A healthy company will have an ROA in excess of 5 percent.