Understanding The Income Statement

Two basic formats for the income statement are used in financial reporting presentations - the multi-step and the single-step, which are illustrated below in two simplistic examples:


Multi-Step Format
Net Sales
Cost of Sales
Gross Income*
Selling, General and Administrative Expenses (SG&A)
Operating Income*
Other Income & Expenses
Pretax Income*
Taxes
Net Income (after tax)*

In the multi-step income statement, four measures of profitability (*) are revealed at four critical junctions in a company's operations - gross, operating, pretax and after tax.
In the single-step presentation, the gross and operating income figures are not stated; nevertheless, they can be calculated from the data provided.

Single-Step Format
Net Sales
Materials and Production
Marketing and Administrative
Research and Development Expenses (R&D)
Other Income & Expenses
Pretax Income
Taxes
Net Income

In the single-step method, sales minus materials and production equal gross income. And, by subtracting marketing and administrative and R&D expenses from gross income, we get the operating income figure. If you are a do-it-yourselfer, you'll have to do the math; however, if you use investment research data, the number crunching is done for you.

One last general observation: Investors must remind themselves that the income statement recognizes revenues when they are realized (i.e., when goods are shipped, services rendered, and expenses incurred). With accrual accounting, the flow of accounting events through the income statement doesn't necessarily coincide with the actual receipt and disbursement of cash; the income statement measures profitability, not cash flow.

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Sample Income Statement


Now let's take a look at a sample income statement for company XYZ for FY ending 1998 and 1999 (expenses are in parentheses):

Income Statement For Company XYZ
FY 1998 and 1999
(Figures USD)
1998 1999
Net Sales
1,500,000 2,000,000
Cost of Sales
(350,000) (375,000)
Gross Income
1,150,000 1,625,000
Operating Expenses (SG&A)
(235,000) (260,000)
Operating Income
915,000 1,365,000
Other Income (Expense)
40,000 60,000
Extraordinary Gain (Loss)
- (15,000)
Interest Expense
(50,000) (50,000)
Net Profit Before Taxes (Pretax Income)
905,000 1,360,000
Taxes
(300,000) (475,000)
Net Income
605,000 885,000

Now that we understand the anatomy of an income statement, we can deduce from the above example that between the years 1998 and 1999, Company XYZ managed to increase sales by about 33%, while reducing its cost of sales from 23% to 19% of sales.


Consequently, gross income in 1999 increased significantly, which is a huge plus for the company's profitability. Also, general operating expenses have been kept under strict control, increasing by a modest $25,000. In 1998, the company's operating expenses represented 15.7% of sales, while in 1999 they amounted to only 13%, which is highly favorable in view of the large sales increase.

As a result, the bottom line - net income - for the company in 1999 has increased from $605,000 in 1998 to $885,000 in 1999. The positive inter-annual trends in all the income statement components, both income and expense, have lifted the company's profit margins (net income/net sales) from 40% to 44%, which is a highly favorable.


Conclusion

When an investor understands the income and expense components of the income statement, he or she can appreciate what makes a company profitable. In the case of Company XYZ, it experienced a major increase in sales for the period reviewed and was also able to control the expense side of its business. That's a sign of a very efficient management effort.

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