Follow the money.
It’s an age-old maxim of journalists, but it works in other areas of life too. If you want to understand how a business works, for example, there’s no better place to look than its financial statements. You can see exactly how the company makes its money, how much risk it’s taking, whether it’s growing or stagnating, and so much more.
The problem, however, is that it feels as if you need an MBA just to decode these statements. Operating income? SG&A expenses? Net income from discontinued operations? What does it all mean?
The good news is that behind the jargon lies a fairly simple story. Once you’ve learned a few key terms, you’ll be able to read and understand the narrative of any business you choose to look at. Learning those terms is exactly what this tutorial is about.
Of the three main types of financial statements, the income statement is the most fundamental, because it tells the story of how the business made money (or sometimes how it failed to make money). We’ll look at the balance sheet and the cashflow statement in future tutorials, but for now it’s all about the income statement, sometimes called the profit and loss statement, or P&L for short.
We’ll go through the statement from top to bottom, helping you understand how it’s structured and what all the different lines mean. We’ll sort through the different types of expenses, and what they tell us about the business. And we’ll examine the other lines you see on the statement, like “net income from discontinued operations”.
You can follow along using the sample data we provide, and then we’ll use what you’ve learned to help you understand a real-world case: Apple’s latest income statement. Finally we’ll look at how European companies’ statements differ from those in the U.S.
By the end, you’ll be able to read an income statement for any company in the world, and feel confident that you understand the story the company is telling.
1. From Top to Bottom Line
You’ll sometimes see variations in companies’ income statements. They might choose to show different details, vary the order a bit, or use slightly similar terms. But the basic structure of every income statement is exactly the same.
The top line gives the total amount of money the company brought in during the year. Then you’ll see that number gradually getting smaller and smaller as all the company’s expenses are deducted, until finally you arrive at the “bottom line” number, which is called net income.
So let’s start at the top, and look at what each line means.
We’ll use the income statement of a fictional company, CoolGadget Corp, as an example. You can download the spreadsheet shown below:
In 2013, CoolGadget sold 1,000 cool gadgets, priced at $100 each, so it took in a total of $100,000 before any costs are figured in. This is the starting point of the income statement: the “top line” revenue number. Revenue has more than tripled in the last couple of years, so the company looks healthy so far.
Cost of Revenue
Each of those cool gadgets, of course, costs money to produce and distribute. $300 each, to be precise, so that’s $30,000 total in “cost of revenue”. That cost has been increasing, too, but that’s what you’d expect when the company is growing.
We need to take the cost of revenue out to get a more accurate picture of how much money the company made. So $100,000 minus $30,000 leaves us with $70,000, which we call “gross profit”.
A company’s expenses consist of more than just the cost of making products. CoolGadget needs a research team to work on designing next year’s cool gadgets, so that it doesn’t fall behind. On top of that, it spends money on marketing and advertising to attract new customers, and employs a sales force to make sure its gadgets are stocked in all the best electronics stores. And then there are the executives, and the admin staff, and the general office overheads.
The research costs are listed under “research and development,” or R&D for short. The other costs are called SG&A: selling, general and administrative. Together, they make up “operating expenses.”
In 2013 these operating expenses added up to $30,000, which leaves us with just $40,000 of “operating income.” This is the money the company makes from its general operations, before taking into account the final category of expenses.
And here’s a slightly worrying detail: CoolGadget spent nothing on research and development in 2013. Looks as if it tried to scrape to profitability by firing its entire R&D team. Good for this year’s numbers, but not a good strategy for the future. That’s why it’s important to look beyond the headline numbers and see what real story the income statement is telling.
Interest and Tax
Hmm, looks as if CoolGadget has been borrowing quite a bit of money. It’s paying $30,000 a year in interest, wiping out most of its profits. Then there’s a $2,000 tax bill from the IRS.
It would be good to see why that interest expense is so high — for that, we’ll need to check the balance sheet in next week’s tutorial.
For now, though, we’ve gone right through the income statement from top to bottom, starting with $100,000 in revenue and listing all the different expenses the company has incurred. It’s time for the bottom line.
Companies are so focused on the bottom line of the income statement that the term has expanded beyond the business world and become a general phrase — or cliché, depending on your point of view — meaning “the most important thing.”
It’s easy to see why. Net income is what’s left over after all the costs have been accounted for. It’s the profit that gets distributed to shareholders at the end of the year — either directly in the form of a dividend payment, or indirectly by being invested in the business and letting shareholders benefit from a rising stock price.
Net income is the most important measure of profitability, however, we've encountered others on our journey from the top of the income statement to the bottom. There was gross profit, for example, and operating income. These terms just give us different ways of talking about a company. You could say, for example, that CoolGadget is showing strong growth in gross profit, but weak operating income.
On some income statements you’ll see other measures, like EBIT (earnings before interest and tax). Sometimes all the different types of profitability can get confusing, but as you’ve seen, the basic structure of an income statement is simple: start with “top-line” revenue, take out all the expenses, and end up with the “bottom line,” net income.
2. Other Lines
Now that we’ve looked at the basic structure, let’s examine a few other lines you’ll often see.
Companies often list income or losses from “discontinued operations”. That's when a company has made a profit or loss from a business it’s already sold or closed down.
For example, you can see that CoolGadget Corp made a $20,000 loss from discontinued operations in 2012. We wouldn’t worry too much about it, though, because the loss-making unit has now been sold off, and won’t be a drag on the company any more.
You’ll also sometimes see “Extraordinary items” separated out towards the bottom. This can be either a gain or a loss, but it’s a one-off event that won’t recur again. CoolGadget took a $25,000 loss in 2012 because its factory was damaged by Hurricane Sandy.
Generally you can disregard extraordinary items when analyzing the long-term prospects of a business, because by definition they’re not going to happen again. Just make sure the company isn’t claiming “extraordinary” events too often!
Finally, you’ll often see ratios at the bottom, particularly earnings per share. This is important for shareholders or potential investors, because it helps them calculate what sort of stock price is reasonable. It’s a simple calculation: just divide net income by the total number of shares.
3. The Real World: Apple’s Accounts
Now that we’ve covered everything, let’s take a look at a real income statement. Here’s Apple Inc.’s 2013 statement, as show on page 45 of its annual report:
You’ll see that some of the terms are slightly different. The top line is “Net sales”, and what we called “Gross profit” is called “Gross margin” here, for example. But the basic structure is instantly recognizable from our CoolGadget income statement.
We can see that sales are growing at a decent rate from year to year, but that gross margin actually fell slightly in 2013. That indicates that the cost of making all those iPads and iPhones is getting higher. Apple is still increasing its spending on research, which is a good sign, but that means operating income has dropped as well. The bottom line: Net income fell for the first time in more than a decade.
Apple’s annual report also provides a lot more detail, letting you see how much it made from iPads, iPhones and Macs, how much it made in different parts of the world, how its costs broke down, and so on. But the high-level, “consolidated” income statement is quite easy to understand, don’t you think?
4. International Differences
So far we’ve covered the U.S. format. There are a few differences with companies based abroad, but the good news is that they’re not major. There’s been a lot of effort in recent years to standardize accounting rules across different countries, so the basic structure will be easy to recognize.
For example, here’s an income statement for British pharmaceutical giant GlaxoSmithKline plc (GSK).
Probably the first thing you’ll notice is that the first line says “Turnover”. Don’t worry, that’s just a British way of saying “Revenue.” And the bottom-line profit number is called “Profit after taxation for the year” instead of “Net income.”
There are other, minor differences too. Interest is listed a little higher than in U.S. statements, for example, and is called “Finance income”/“Finance expense”.
But as you can see, the basic structure is the same. You can still read the income statement using the rules you learned for the U.S.
It’s the same for other European countries: minor variations, but the same basic rules. Here’s the German auto maker Volkswagen AG, for example:
Understand the Business Story
You can now read an income statement, and use it to understand the story a business is telling. Whether you want to understand your own company's accounts, evaluate competitors, or find investment opportunities, you should now be able to do it with more confidence.
For public companies, the income statement is easy to find. The best option is a financial website like Morningstar or Yahoo Finance, where the statements are available to review. They are laid out in a standard format, which helps you compare various companies.
If you want the company’s own original accounts, with the accompanying commentary and explanation, you can download the latest annual report from the company’s website, which is usually located in the “Investor Relations” section, or access the reports it filed with the Securities & Exchange Commission.
Try looking at a few different companies and understanding the story they’re telling you through their accounts. Keep an eye on the trends from year to year, and start to ask questions if you’re not seeing continuous growth, or if any of the expense items seem particularly high.
With practice, it will get easier and easier. If you come across the balance sheet and don’t know how to read that, don’t worry: we’ll cover that next.