The Income Statement: How to Read Financial Statements Like a Pro (Part 2)

A Crash Course in Balance Sheets, Income Statements, and Statements of Cash Flows

Welcome back friends!  Today we’ll be diving into part 2 of 3 of our miniseries on analyzing financial statements.  In this module, we’ll be learning all the income statement.  

And for those of you who missed it, check out Part 1 of the miniseries: The Balance Sheet.

Let’s jump in, shall we?

Part 2: The Income Statement

The income statement, also known as the Statement of Profit and Loss, shows a company’s income and expenses over a defined period of time.  If you’re looking at a company’s annual 10K report, you’ll oftentimes see the income statement is shown over period of a year with the ending date being the company’s fiscal year-end.  For instance, let’s assume a company is on a calendar year. This means that the company’s year-end is 12/31/20XX.  In this scenario, the income statement will reflect income and expense transactions for the period 1/1/20XX to 12/31/20XX.

Publicly traded companies also issue quarterly reports, called 10Qs. The income statement in a 10Q report should reflect income and expense over a period of 3 months for Q1, a period of 6 months for Q2, and – you guessed it – a period of 9 months for Q3.

Please note that a “smaller reporting company” or an “emerging growth company” may be eligible to rely on scaled disclosure requirements under the Exchange Act (SEC.gov). That said, it’s important to do your own research on a company’s specific reporting requirements prior to investment. To find out more information about the IPO process and reporting requirements, the SEC website is a phenomenal resource!

Now, let’s analyze a sample income statement!  We’ll return to my fictional ice cream shop.  An income statement for Mikaela’s Ice Cream might resemble the following:

Net Sales

The first line in my income statement shows the company’s net sales, or revenue.  So, in year 1, assume I sold 1,180 cups of ice creams for $5 each.  1,180 cups multiplied by $5 per cup of equals $5,900. The $5,900 amount represents the company’s year 1 revenue.  Then, in year 2, Mikaela’s Ice Cream sold 5,940 ice creams. How do I know this? Well, year 2 revenue totaled $29,700, as shown above. So, if I take my revenue of $29,700 divided by $5 per cup, I must’ve sold 5,940 cups.

Cost of Goods Sold

Most companies also have cost of goods sold. In our example, cost of goods sold represents the cost of the ingredients needed to make the ice cream.  Let’s assume in year 1, my supplier charges me $3.75 for the ingredients per cup of ice cream.  Since I sold 1,180 cups in 2022 my cost of goods sold would be $4,425 (1,180 * $3.75).  This also gives me a profit margin of 25%, calculated as $5,900 minus $4,425 and then divided by $5,900.  

You’ll notice my year 2 profit margin improved drastically to 40% ($29,700 minus $17,820 divided by $29,700).  Why you might ask?  Because Mikaela’s Ice Cream switched suppliers to a locally sourced farm, cutting down costs to transport the ingredients. So, instead of $3.75 to produce a cup of ice cream, it now only costs $3.00 per cup.  This is the sort of thing you as an investor should be interested in!!!  And oftentimes, you’ll see this detail disclosed in the notes.  So, again just a friendly reminder to read the notes in conjunction to analyzing the numbers. 😉

Another point I want to mention briefly is that the cost of goods sold not only include the costs of ingredients, but also includes direct labor costs.  In my example, direct labor might be the high school or college-aged kids I employ to scoop and serve ice cream to customers.

Selling, General & Administrative

The next section of the income statement I want to highlight shows selling, general & administrative (SG&A) expenses.  These are your expenses that don’t directly relate to producing the product, but are still important and necessary for the business to operate as intended.

For example, this might include advertising costs or costs associated with hiring a bookkeeper to track the company’s finances.  And again, it’s imperative to read the notes to gain clarity on what exactly is included in this bucket, as every company is different.

Other Income and Expense

Below SG&A is other income and expenses.  You might want to think of this as a catch all for all the other income expenses that aren’t as easily categorized.

Returning to my example, let’s assume Mikaela’s Ice Cream only operates 6 months out of the year. In the winter when the demand for ice cream is low, Mikaela’s Ice Cream rents out the space for $2,100/month, starting in year 2.  Total income generated from rental activities equals $12,600. Moreover, this represents other income as it doesn’t relate to the core business activity of selling ice cream.

Other common examples include interest income, or conversely interest expense.  If you recall from Part 1: The Balance Sheet, Mikaela’s Ice Cream has a $420,000 loan.  Assuming an interest rate of 1.75%, Mikaela’s Ice Cream would pay interest expense of $7,350 in year 1 and $7,105 ($406,000 balance remains on the loan) in year 2.  Similar to the rental activity, interest expenses incurred do not directly relate to day-to-day business activities, so would be classified as other expense.

Net Income (Loss)

The income statement also shows a company’s profit, or net income.  Moreover, if the company is operating at a loss, the income statement will instead have the terminology “net loss”. This is reflected towards the bottom of the income statement, above any earnings per share information. 

In my example above, you’ll notice for the first year in business, Mikaela’s Ice Cream had a net loss of $12,300.  During its second year in business, the company recognized net income of $13,700.

These amounts (less any dividends) roll up into retained earnings.  Because Mikaela’s Ice Cream is still a growing company, let’s assume the company didn’t pay any dividends to shareholders.  So, the first year in business, the company’s retained deficit equaled the company’s net loss amount of $12,300.  In the second year, retained earnings totaled $1,400, which was the negative $12,300 from year one plus the positive earnings of $13,700 from year two.

Net income (loss) continues to roll up into retained earnings every year.  And in the case of dividends, the increase or decrease in retained earnings will be the net income or loss minus dividend payments.

Earnings Per Share

Although my example above doesn’t show it, it’s common for publicly traded companies to show earnings per share information on the face of the income statement, below the net income (loss) line.

I will discuss earnings per share in greater detail in a future post. For now, simply be aware that it shown on the face of the income statement.

Next Steps to Analyzing Income Statements

Now that you have a solid understanding of the income statement, go forth and try your hand at analyzing income statements for publicly traded companies using the SEC’s Edgar Search Tool.

Also, check out my latest stock analyses and share your thoughts!