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The income statement

The income statement is the simplest of the three financial statements to understand—it is merely profit and loss—yet it is the most frequently misunderstood. This is because the definition of "profit" is not as straightforward as it seems. Revenue minus expenses equals profit, but the word "expenses" can mean many things depending on who is drawing the line and when they are drawing it.

The income statement tells you whether a company made money over a specific period of time, usually a quarter or a year. But it does not tell you whether that money was real cash or an accounting construct. It does not tell you whether the profit is sustainable or a one-time event. It does not tell you whether the company is reinvesting in growth or living off its assets. For those answers, you need to read the other two statements in context with this one.

Structure: from top line to bottom line​

The income statement flows from the top line (revenue) to the bottom line (net income). Every line in between is a step down in profit. Some steps are direct costs of producing the product (cost of goods sold). Some are the overhead of running the business (operating expenses). Some are the cost of financing the business with debt (interest expense). Some are taxes owed to governments. And some are unusual or one-time items that distort the normal economics of the business.

The art of reading the income statement is learning to see which line items are structural (they tell you about how the business works) and which are noise (they obscure the true operating profit). A company that records a one-time gain from selling a subsidiary might show a large net income in the period of the sale, but that income tells you nothing about whether the ongoing business is profitable. A company that takes a large write-down on inventory might show a loss in that period even though the operating business is healthy. An investor who reads only the net income number might miss what the underlying business is actually earning.

What the statement reveals and conceals​

The income statement reveals the top line—the total revenue the business generates—which tells you the size of the addressable market the company is capturing. It reveals the gross profit, which tells you the fundamental profitability of the product or service before you pay for overhead. It reveals the operating profit, which tells you whether the core business is profitable after paying all day-to-day costs. It reveals the pre-tax profit, which tells you the profit available to the company before taxes. And it reveals the net income, the profit available to shareholders after all claims on the business have been satisfied.

But the income statement conceals as much as it reveals. It uses accrual accounting, which means it records revenue when a sale is made, not when cash is received. This is why a profitable company can run out of cash. It allows companies to capitalize certain expenses (record them as assets) instead of expensing them (recording them as immediate costs), which shifts profit between periods. It does not tell you the cash cost of inventory; it tells you the accounting cost. And it allows management discretion in many areas: how aggressively to reserve for doubtful customer accounts, when to recognize revenue, how quickly to depreciate assets, whether to record a customer agreement as a short-term liability or a long-term asset.

Reading for the story, not the number​

The number that matters most varies by company and by business model. For a retailer, gross margin—the percentage of revenue left after the cost of goods sold—is critical; a company that cannot maintain margin is failing at the fundamental job of being a business. For a technology company, operating margin is more important; the revenue is secondary to whether enough of it falls to the bottom line. For a financial institution, the net interest margin tells you whether the core business model is viable.

The income statement also tells a story about scale and leverage. As a company grows, can it grow operating expenses slower than revenue? That is operating leverage, and it is where value gets created. If a company grows revenue twenty percent but operating expenses grow twenty percent also, nothing is happening to profit. If revenue grows twenty percent and operating expenses grow ten percent, the profit grows much faster. This is why the margins matter more than the absolute profit number.

The income statement is the first place an investor looks, but it is also the easiest place to be misled. This chapter explains every line, teaches you the traps, and shows you how to use the income statement as a starting point for understanding whether a business has a mode of making money, and whether that mode is strong or weak.

Articles in this chapter​