Understanding the Income Statement

An Income Statement is a standard financial document that summarizes a company’s revenue and expenses for a specific period of time, usually one semester of a fiscal year and the entire fiscal year.  It is important that both investors and company managers be able to read and understand this document in order to understand the company’s financial condition.

Readers will remember that I said that the balance sheet was the photo – a before photo for the start of the financial year, and an after photo for the end of the financial year.  The income statement is the video that tells you what happened during that financial year.  Twelve monthly balance sheets do not add up to an annual balance sheet.  This is like taking 12 pictures of yourself during a year and then adding them together to say this is what you liked like for the year.  However, 12 monthly income statements do add up to the annual income statement.

Also, we said that the balance sheet deals with capital items.  The income statement deals with revenue items, i.e. the income and costs and expenses for that specific period.

The main items of the income statement are dealt with now.

Sales Revenue

  • Often called the “top line,” this represents the amount the company has sold during the period.  When there is more than one line of revenue shown above the Total Sales Revenue, it provides detail as to which products or services are major revenue producers.
  • What drives the sales revenue?  What is important here are the two factors of volume and price.  And they in turn are driven by the market segment and the industry you have selected to operate in.
  • For example, you may choose to operate in the wine industry, and having made that decision, you may choose to be a bulk wine provider (segment) and not an ultra-premium or icon wine producer.  For the bulk wine producer, the volumes will need to be high as the price will tend to be low.  An example in the food retail environment would be the USave brand of the Shoprite group.  For the ultra-premium wine producer such as Durbanville Hills, the volumes sold will be much less but the price would be much higher.
  • Your company’s strategy is to find sources of revenue where you can have both high volumes and good prices.  We need to be realistic though that they would not always run together (they seldom do!).
  • Shoprite has chosen to expand into Africa to generate revenue without the intense rivalry they are experiencing within South Africa against Pick ‘n Pay, Spar, and Woolworths.  Pick ‘n Pay has recently also made the decision to expand into Africa again as they have seen the impact this expansion has had on the revenues of the Shoprite Group.
  • So when you analyse the revenue figures of a company, you need to look at it from a strategic perspective.
  • You also need to ask yourself how much this figure has grown relative to last year.  If your growth is less than the inflation figure, it would not be a real growth.
  • Growth in revenues are supported by assets, both fixed and current assets.  Should you double your revenue, it would have a strong impact on the fixed assets, if the assets had been fully utilized.  If not, then the existing fixed assets could be used more efficiently to produce the revenue.
  • Working capital tends to double with a doubling in revenue.  Here we refer to the items debtors, stock, and creditors.  More of this when we chat about the ratios of the company.  The point that I need to make here is that strong growth in revenues could have a negative impact on the financing requirements.  The growth in revenues will necessitate a strong growth in working capital and this will need to be financed from somewhere.

Sales Costs

  • This is what it cost the company to generate the sales shown in Total Sales Revenue above.  Compare the total costs to the total revenue, but also look at the cost of each line of product or service versus its revenue. Sales Costs is also known as Cost of Goods Sold (CGS).  Service companies such as a consultancy do not have a cost of goods sold figure, nor do banks and insurance companies.
  • Banks have a cost for the interest income they have made.  Loosely speaking, they generate an interest income, and this money is made by lending out money to you and I.  It does come at a cost to the bank.  Generically, this could be equated to a cost of sales.
  • Insurance companies would have a premium income as revenue, and their cost of sales could be seen as the claims by their policy holders.
  • Getting back to a retail example, you need to buy goods of the required quality and standard at as low a price as possible, and sell it at at the price that your customer segment will be willing to pay.

Gross Profit or (Loss).

  • This is the difference between Sales Revenue and Sales Costs.  If the difference is positive, and it had better be, it is profit.  A negative difference is a loss and is shown in brackets.  For banks there would be a different term, and for insurance companies also another term.
  • Banks talk about net interest income.  When you add something they call non-interest revenue (commission and fees), one would get their net income.
  • Insurance companies have an underwriting profit.  Sometimes they take the premium income, subtract the claims, and then add to that figure the returns they generate by investing the reserves they need to cover the possible claims.  This would then constitute their version of gross profit.

Operating Expenses constitute expenses such as:

  • General & Administrative expenses
  • Sales and Marketing expenses
  • Research & Development expenses

Operating expenses need to be managed closely.  Companies that have succeeded in building an operating model that is lean and mean, can actually use this as a source of competitive advantage.  A good example would be SABMiller, the global beer producer.  Although it is important to have a lean operating model, beware of cutting costs for the sake of cutting costs.  I feel that we should optimize our operating expenses and not necessarily minimize them.  I do not mind to pay an entertainment expense of thousands, if the salesperson brings home the business to justify this expense.

    General & Administrative Expenses

    • These are the costs associated with running the company as opposed to the costs of making or buying the products (CGS above).  These costs should be monitored closely and kept as low as possible (within the guideline of optimization as stated above).  They would include items such as salaries, travelling, rental, telephone, electricity, entertainment, and depreciation, amongst others.
    • Depreciation is an item we need to talk about.  When we acquire a capital item such as a vehicle, we do not affect the income statement.  However, after the vehicle had been used, let’s say for the year, it has undergone some wear and tear.  This wear and tear is referred to as depreciation, and is viewed by the Receiver of Revenue as a legitimate expense of doing business.  It is therefore deducted as an expense in the income statement.  As it is not a cash expense (you do not pay it to anybody), the only impact it has is on the amount of tax you pay.  It reduces the taxable profits and you pay less tax.
    • Depreciation is therefore said to provide a tax shield, the value of which is the tax rate times the depreciation charge.
    • This is the only way a capital item (purchasing of a fixed asset) gets onto the income statement, which deals with revenue items.
    • A figure that is also used is amortization.  This can loosely be seen as the depreciation of an intangible asset.

    Sales & Marketing Expenses

    • These are other costs not directly related to producing the product or service to be sold.  While certainly necessary, sales and marketing costs should be monitored and compared frequently to similar numbers from other companies in the same industry with products in the same point in the life cycle.
    • In difficult times many companies tend to cut their marketing expenses.  This is maybe not the best thing to do, as it is probably exactly in these circumstances that you need to build your brand in the market.

    Research & Development (R&D) Expenses

    • This is the part of its income a company is re-investing in the business to find and develop new products.  It’s an indication of how much management values innovation.  Look at whether this figure is increasing or decreasing from year to year.
    • If you are in an  industry where new products or technology are important, such as the mobile telecommunications industry, you need to invest a considerable amount in this expense category.
    • Companies that do not make this investment should raise concerns amongst investors.

    Operating Income

    • This is what is left when one subtracts all the operating expenses (G&A expenses plus Sales and Marketing expenses plus R&D expenses) from Gross Profit.  It is also referred to as EBIT (earnings before interest paid and tax).
    • It is important to see what companies do include or exclude when they refer to the item operating profit.  This is a term that is used rather loosely.

    Earnings before interest, tax and depreciation and amortization (EBITDA)

    • This is a figure that is frequently used and refers to Operating income with depreciation and amortization counted back.  The philosophy behind the figure is that investors frequently would like to understand the performance of the company before depreciation and amortization are taken into consideration.  The last 2 concepts are not real expenses and can easily be manipulated.

    Income before Taxes

    • After subtracting any interest paid on outstanding debt from Total Operating Income you are left with Income before Taxes (or Profit before Tax).  This is the amount on which the company expects to have to pay taxes.

    Taxes

    • This is the amount the company has paid or expects to pay in taxes for the period.  It includes all taxes to all jurisdictions.

    Net Income from Continuing Operations

    • After subtracting taxes from its income, this is what the company has left.  Think of it like a worker’s take-home pay.

    Profit Margin

    • This varies from industry to industry, but is a good measure to compare similar companies, from either an investment or a benchmarking perspective.  It is like the interest rate you get on your investment.

    Non-recurring Events

    • This is the cost of any one-time expenses, for instance, restructuring the business, a major layoff, or an un-reimbursed casualty loss.  These are shown on a separate line so as to not confuse the “continuing operations” figure above.

    Net Income

    • This is what the company has left after subtracting all its expenses from its total revenue.  If the difference is positive it is profit. A negative difference is a loss and is shown in brackets. For a company to remain healthy and in business, this number needs to be positive most of the time.  Most for-profit companies strive to make it as big a positive number as possible.

    Dividends to Shareholders

    • Companies pay dividends to the shareholders who own the companies.  If any dividends have been paid during the period being reported, they are shown on this line. These can be to common or ordinary shareholders, preferred shareholders, or other investors depending on the company.  Some companies pay dividends only once a year, while others pay it twice.  The first dividend is referred to as an interim dividend, while the last dividend is referred to as a final dividend.

    Net Income Available to Shareholders

    • This is “the bottom line,” the money the company has left at the end of the period.  It is held for future needs, invested as the Board directs, or returned to investors in the future.  It is transferred to the Retained Earnings figure as part of Equity.

    Headline Earnings

    • This method accounts for all the profits and losses from operational, trading, and interest activities, that have been discontinued or acquired at any point during the year.
    • Excluded from this figure are profits or losses associated with the sale or termination of discontinued operations, fixed assets, or related businesses, or from any permanent devaluation or write off of their values.

    The following example provides an outlay of a typical income statement.

    The strategic literature abounds with references to a company’s need to manage the items on its income statement.  Although the section on the profitability ratios need to be studied as well, the following is equally true.

    Kim & Mauborgne (Blue Ocean Strategy, 2005: 131-137) refer to the need to start off with the strategic price of the product or service.  This is the price the market will be eager to buy the product/service.  Once the strategic pricing is set, the costing needs to be done in order to arrive at the profit of the new business model. This is done through target costing and aims to maximize the profit potential of the blue ocean idea. The target cost is derived through the following simple equation:

    Strategic Price – Desired Profit Margin = Target Cost

    This ensures an aggressive and profitable model that is hard for competitors to follow. The challenge is to build a strategic profile that has divergence as well as focus in order to strip out costs. The model identifies three principle levers to hit the cost target.

    First lever: Streamline operations and introduce cost innovations across business.

    • Can high cost, low value-added activities in your value chain be eliminated, reduced or outsourced?
    • Can you shorten production steps by reorganizing the way things are done?
    • Can you digitize activities to reduce costs?

    Second lever: Partner with other companies to share and reduce costs

    • Secures needed capabilities fast and drops cost structure.
    • Allows you to leverage other companies’ expertise and skills.

    Third lever: Change the pricing model of the industry

    • By changing the pricing model, you do not have to adjust the strategic price.
    • There are a few models available: Time share, Slice Share, Equity interest and Pricing innovation.