Income Statement Introduction

In this article we will give a description and discuss the details of a financial statement. This will include both the balance sheet and the income statement. We will also discuss common financial ratios and how they are derived from these statements.

The Income Statement

The income statement is simply an account of the money a company receives and how it filters through the various costs.

We will use the income statement for Wrigley (WWY) 2006 annual report as an example.

We will start of by calculating the operating income. This is simply the net profit from operating the core entity of the business.

The first line contains the revenue. This is simply the price of goods multiplied by the quantity sold. The figure presented on the income statement is 4686 million USD. (Goods can also refer to the price per hour of services for example what consultants charge per hour multiplied y the total hours worked.

The next line is “Cost of Goods Sold” This is simply the actual cost of producing or acquiring the products which were sold. For example a steel companies cost of good sold is the cost of the raw steel as well as the energy consumed to melt the steel, roll, package and send it. The cost of the facilities is not included in this line however.

Total Revenue – Cost of Goods Sold (COGS) = Gross Profit 

Some income statements also have an entry for restructuring charges. This is related to severance and employee benefits costs and costs associated to close those facilities. This means that we also subtract restructuring charges from the total revenue to arrive at the gross profit. Wrigley is one company where the income statement contains this line. Restructuring expense is also known as “Unusual Expense” (this is different to extraordinary expense).

Selling General and Administrative Expenses are are the expense associated with the operations of the business, including, office rental, employment costs, as well as consultancy and legal fees. This leads to

Operating Income = Gross Profit - Selling General and Administrative Expenses 

Interest expense is simply the interest payments that the company has to pay on the bonds that it issued and the bank loans that it took.

Investment Income is the profit or loss of non operating investment ventures that the company undertook. For example if they have an in house portfolio manager which invested some of the assets or perhaps they invested in some real estate. Many analysts are more interested in operating profits because interest and investment income are not directly related to the actual core business. After netting operating income for the above additions we arrive at

Earnings Before Income Taxes (EBIT) = Operating Income – Interest Expense – Investment Income – Other Income (Expense) net

Income taxes are charges as a % of profit. So if a firm will charge 40% income taxes, this figure is deducted from the EBIT figure to arrive at

Net Income = Earnings Before Taxes – Taxes

Ratios Relating to the Income Statement

Before we begin calculating the ratios it is important for us to take two other variables into account. One of them is a stable figure known as “Shares Outstanding” which is the total number of shares available, and the other variable is “Price” which constantly changes.

Having a net income figure is great but it would be a lot more interesting how much income each share generates. If a company generates 100 000 dollars a year and there are a million shares outstanding then each share only makes 10 cents!

If I was only analyzing SORC by itself then maybe I could handle knowing the net income, but most traders, investors and analysts are interested in comparing one company with other companies in the same industries. Furthermore the price at which a company is trading at could make the stock look cheap if the net income is high relative to the price. Let us begin with the earnings per share.

Earnings Per Share (EPS) = Net Income / Shares Outstanding

P/E Ratio = Price per share / Earnings Per Share (EPS)

This is simply a multiple of the price relative to its net income also refered to as the earnings multiple. The earnings yield is the inverse of formula

Price to Sales Ratio = Price per share/Sales (Revenue) per share
Profit Margin = Net Income / Total Sales

Operating Margin = Operating Profit / Total Sales