An Income Statement is a financial report that shows how much revenue and expenses a company accrues over a particular period. Also known as the Profit and Loss Statement, the Income Statement is one of the 3 key financial statements. This Statement gives insights into a company’s performance, operations, profitability and management efficiency.

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What is the Income Statement?

The income statement is a crucial financial statement that reflects how much a company earns from selling its products and services, along with the costs and expenses incurred to conduct its business operations. It is also known as the Profit and Loss (P/L) statement, as it records whether a company has made a profit or loss during a specific reporting period. It does not differentiate between cash and non-cash receipts.

Overall, the income statement summarises a business’s performance. The management’s top priority (from an Income Statement perspective) is to increase the top-line sales, manage expenses effectively, and increase the bottom-line profit of the business.

The income statement starts with the revenue (top-line) and ends with the net income (bottom-line) after deducting all business operating costs. The net income is what creates the craze on the street over the short-term, with a focus on earnings, earnings beats, earnings misses, and earnings per share (EPS).

The income statement follows quarterly and annual reporting periods, and the focus on this statement plays a significant role in the “voting machine” over quarterly earnings reports.

Although the income statement involves technical terms and accounting methods, it is relatively easy to understand and follow. It’s best to analyse it line by line, starting from the top, to understand how a company arrived at its bottom-line number.

Why is the Income Statement important?

The Income Statement is an essential financial document that provides valuable insights into a business’s financial performance and operational efficiency. It is used by investors, analysts, managers, and lenders to understand how much the company is selling, how it operates, and how it uses its revenue to run the business. It also reveals how much profit is left over at the end of the day.

The Income Statement has many line items that make up the overall statement. These line items are divided into operational activities that the business depends on to survive and non-operational activities that are important but not detrimental to the core activity of the business. It is important to be aware of these two distinctions.

The statement is valuable because it shows how much a business is growing by increasing its sales, how efficient the company is while delivering its products and services, and how effective it is in turning top-line revenue into profits. From the top-line sales to the bottom-line earnings, there are many items in between that influence the final outcome.

A firm’s income statement may be, likened to a bikini-what it reveals is interesting but what it conceals is vital.

Burton Malkiel

Analysing an income statement can reveal a lot about the business and whether it presents a viable investment opportunity. However, it is important to be aware that businesses can “engineer” line items and use fancy accounting methods to make themselves look better than they are. Therefore, it is crucial to understand how the numbers are derived and how “growth” has been achieved.

Overall, understanding the Income Statement is important because it provides a clear picture of a company’s financial health and helps stakeholders make informed decisions.

Two ways to read the Income Statement.

An Income Statement can be read using two methods. Vertical Analysis and Horizontal Analysis.

Vertical Analysis is a financial analysis method that expresses each line item as a percentage of the base figure, which is revenue at 100%. Instead of showing line items in their monetary amounts, they are represented as a percentage of the revenue. This approach helps to compare the relative size of different line items. It also allows for comparison between different periods within the company or against competitors in the same industry. For example, if Marketing and Advertising costs are $100 and top-line sales are $1,000, then Marketing and Advertising would be shown as 10% on the statement. This way, we can evaluate how much a company is spending on marketing and advertising as a percentage of revenue.

Income Statement	% of Revenue
Total Revenue	100%
Cost of Goods Sold	55%
Gross Profit	45%
Operating Expenses	15%
Depreciation Expenses	10%
Interest Expenses	5%
Income Tax Cost	3%
Net Profit	12%

Horizontal Analysis, on the other hand, looks at changes in costs over time. It compares last year’s results to the current year’s results to analyse the changes, their impact, and where they occurred. For instance, if revenue is growing, we may find that sales and administrative costs are also increasing. By comparing the numbers, we can see how a company is evolving, either quarter over quarter or year over year. It helps identify trends in a company’s income statement.

Income Statement	2023FY	2024FY	% YoY
Revenue	$100	$110	+10%
COGS	$60	$65	+8.3%
Gross Profit	$40	$45	+12.5%
Operating Expenses	$10	$11	+10%
Depreciation Expenses	$10	$10	0%
Interest Expense	$5	$3	-40%
Income Tax Cost	$5	$7	+40%
Net Profit	$10	$14	+40%

Using both forms side by side is the best approach not one over the other.

The Key areas of the Income Statement?

The income statement is often used to forecast future sales and earnings of a business and so becomes the foundation of a lot of analysis. To truly understand a company an investor needs to dig within the income statement to understand how the business operates. Each line item will tell a story.

Whilst companies within the same industries often mirror similar income statements, every company has a unique financial makeup. What sets great companies apart is often how they convert revenue into profits. I love the quote “Opportunity is found on the income statement…”. This is true, whilst financial health and risk are found on the Balance Sheet and the real money is found on the cash flow statement i.e. Free Cash Flow, the opportunity for a company is in the Income Statement.

This is the first statement I go to, although the Cash Flow Statement is the most important one for me, the income statement helps me to see the bigger opportunity. I want to see Revenue, Expenses, Gains, and losses in context. If it’s a loss-making company, why? Is it poorly run or efficiently reinvesting earnings into more top-line growth? If a company is profitable, why? Is it sustainable and organic or by using unusual accounting methods?

Let’s walk through some of the key line items on an income statement. We will use an example of small single standing food truck operation selling burgers for each of the line items below.

Let’s call the food stand Burgers United Ltd.

Revenue/Sales

Revenue or Sales is the top-line item of all the financial statements. It’s why a business is in business. To sell its products and services to consumers. Revenue that is reported over a given period is the total amount a company has brought in from its activity. This is “Primary Activity”, also referred to as Operating Revenue. So, for Burgers United Ltd, the primary activity is selling burgers. Let’s assume they sell 100 burgers to hungry customers each year and charge $4.95 per burger the total revenue would be $495 for the annual period.

Non Operating Revenue

Some businesses also have another line item under revenue called Non-Operating Revenue and this is income from non-core business activities. Any income that is not related to the typical activities of the business falls under this section. It may be derived from the interest the company earns on cash in the bank, investment activities, currency exchange, or perhaps rent from a property the company owns. Sometimes it is recurring and other times it is a once off. So, for example, Burgers United Ltd if it were to place retained earnings into a bank account and earn interest, this would be labelled as Non-Operating Revenue.

COGS (Cost of Goods Sold)

COGS (Cost of Goods Sold) is the costs or expenses to produce the company’s products and services. This is a direct cost related to selling the primary activity of the business. It could be raw materials, manufacturing, direct labour, and delivery costs. COGS excludes indirect costs like overheads. So, using our Burgers United Ltd example, if we break down all the components that go into a burger, we will come to our COGS. There is a bun, a meat patty, tomato, lettuce, chilli sauce, cheese, an egg, and then a branded wrapper to package it all up. If all the ingredients and packaging comes to $2.20 then that is the cost of sales to sell a $4.95 burger.

Gross Profit

Gross profit is the profit made after a company deducts the Cost of Goods Sold from the revenue it has brought in. From the Gross Profit, you can work your way down the income statement deducting all the other costs associated with running the business. Extending on from our example, Burgers United Ltd sold 100 burgers bringing in $495. We know the cost to produce each burger with all the ingredients was $2.20. So, the COGS for the period is $220. Revenue ($495) – COGS ($220) bring a Gross Profit of $275. This works out to be a 55.55% Gross Profit Margin.

SG&A (Selling, General & Administration)

SG&A costs are some of the significant overheads associated with running a business. These expenses include rent, wages, property expenses, insurance costs, utilities, accounting costs, and other operational expenses. These are the fixed costs that enable the business to function. Although not directly related to the primary activities such as the Cost of Sales, these operational costs are essential for the business to sell its products or services. They are also known as the “Cost of doing business.” For instance, in the case of Burgers United Ltd, the SG&A expenses would include rent paid for the space, insurance to protect the business, utilities to cook and clean, and wages paid to the owner, which total to $145.

Marketing, Promotional Expenses & Advertising

Marketing and advertising expenses are often included in SG&A. Most businesses have some form of marketing, selling, and advertising activity, which is incredibly important as it helps determine customer acquisition cost and return on investment on marketing costs. Some companies rely heavily on marketing and selling to promote their primary activity, so it can be broken down into its own line item. It is an operational expense as without promoting itself, a business cannot draw in new customers. Burgers United Ltd chooses to advertise their juicy and delicious burgers on a billboard, costing them $5.50 per year.

D&A (Depreciation & Amortisation)

D&A are methods used to allocate the costs related to an asset over its useful life. Depreciation is the reduction in the value of a fixed asset, such as Property, Office Equipment, or Machinery, over time. On the other hand, Amortization is the reduction in the value of intangible assets, such as Goodwill, Patents, or Trademarks, over a certain period. The main purpose of these methods is to spread the cost of an asset over its useful life. Assets have a finite life, and their value decreases over time. For example, in the case of Burgers United Ltd, their food truck costs $1,000, if we depreciated this over 20 years with $0 salvage value. Depreciation would be $50 per year.

EBITDA

EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization) is a financial measure that indicates a company’s overall financial performance. It reflects the profitability of the operating business only, and excludes other non-operating expenses such as interest on debt, taxes, depreciation and amortization. EBITDA can be calculated by adding operating income (EBIT) + Depreciation + Amortization or Subtracting SG&A From Gross Profit. For instance, if we take Burgers United Ltd’s Gross Profit of $275 and deduct the SG&A of $145 and the marketing expense of $5.50, add back in D&A of $50 we get an EBITDA of $174.50. This means that the EBITDA margin is 35.25%.

EBIT (Operating Income)

EBIT (Earnings Before Income Tax) or Operating Income is what a company earns from regular business operations. This form of accounting includes all the operational expenses and income except interest and taxation expenses. The formula is gross profit minus operating expenses (COGS, SG&A, R&D, S&M). EBIT Does not add back in depreciation and amortization. EBIT is a good measure of a business’s core operations without the impact of costs of capital and income tax expenses. In the case of Burgers United Ltd the EBIT is Gross Profit taking all operational expenses or EBITDA minus D&A. So, it will be $174.50 – $50 = $124.50 or 25.15% Operating Margin.

Interest Expense

Interest expenses are the cost of servicing debt. The Interest expenses are tax deductible and are therefore further down the line item before income tax costs. This is the repayment of interest on debt (NOT REPAYMENT OF DEBT), it is simply the servicing costs of borrowing money. Burgers United Ltd took out a $500 loan and services the loan with a 5% interest payment annually, therefore the company has a $25 interest expense each year.

Other Expenses

Other expenses are usually industry or company-specific. It could be SBC (Stock-Based Compensation) to retain talent or reward employees. It could be the company needs to spend a lot on R&D (Research and Development) to continually be innovative. Sometimes it will include the gain or loss of the sale of an asset. It’s best to dig into these line items to find out exactly what is buried within. In our example, Burgers United Ltd has no other expenses.

EBT (Earnings Before Tax)

Earnings before tax is simply the operational income or EBIT minus the interest expenses. It’s the final amount that is left over before considering tax implications. It is handy to compare businesses across different tax jurisdictions that have entirely different net profits due to lower or higher taxes. EBT is a good measure of the company’s profitability and overall efficiency.  Burgers United Ltd had an EBIT (Operating Margin) of $124.50, so we minus the interest expense of $25 to get to an EBT of $99.50.

Income Tax

Income Tax is a government tax on EBIT or operating profit. This may change depending on the tax jurisdiction the company operates in. This line item can include current and future tax obligations. The calculation is simply EBT (Earnings Before Tax) minus the tax the company must pay. In our case, Burgers United Ltd is in a country with a 20% corporate tax rate. Therefore the tax owed is 20% of $99.50 which equals to $19.90 of Income Tax.

Net Income (Pure Earnings)

Net Income (NPAT) is the final line item on the Income Statement and is simply pre-tax income (EBT) minus income taxes. This final amount is considered Earnings which EPS (Earnings Per Share) is based on. The Net Income is also the amount and line item that flows through to the balance sheet and is called “Retained Earnings”. This is the “Bottom Line” of the income statement and the most important for investors to monitor. It will either be a profit or loss depending on the inputs of all the line items above it. In the case of Burgers United Ltd, the final Net Income is EBT – Income Tax which is $99.50 – $19.90 leaving a Profit of $79.60.

EPS (Earnings Per Share)

EPS (Earnings Per Share) is a simple calculation that takes the total earnings (Net Profit or NPAT) and divides it by the number of outstanding shares on issue. This calculation shows how much earnings you get for each share of the company owned. It is an important metric and probably the most talked about across the investment universe. The large amount of noise over the short term is built up on EPS beats and misses. As a final example, let’s assume Burgers United Ltd has 100 shares on issue, the Earnings Per Share would be $79.60 divided by 100 Outstanding Shares leaving 0.796 cents of EPS.

Putting our example into a table.

While Burgers United Ltd is a simplified example, it demonstrates how an Income Statement flows. There are more detailed breakdowns of each line item, and areas like Depreciation and Amortization can impact the final earnings. However, once you understand how the Income Statement comes together, it becomes easier to analyse each of the numbers.

It is best to approach the Income Statement as a top-down analysis. Experienced investors can do a bottom-up reconciliation by taking net income and then adding back the D&A, taxes, and interest to get to EBITDA. The approach depends on the type of company and how its capital structure operates.

Some companies have simple financial statements that are easy to follow, while others can be confusing. The items like D&A and other expenses/income or non-operating expenses and income depend on the type of business model and structure and how the business uses its capital.

Referring to the table below shows how each line item of Burgers United Ltd was determined. It helps to illustrate how we came to the final earnings.

Burgers United Ltd	$	Notes:
Revenue	$495	Sold 100 burgers @ $4.95 each burger.
(-) COGS	$220	The cost of all the ingredients and packaging = $2.20 each.
Gross Profit	$275	Revenue – COGS
(-) SG&A	$145	Wages, Rent, Utilities, Insurance “Costs of doing business”
(-) M&A	$5.50	The cost to advertise on the billboard.
EBITDA	$174.50	Costs excluding the impact of D&A.
(-) D&A	$50	Depreciated the food cart over 20 years from $1,000.
EBIT	$124.50	EBITDA minus D&A to get to our operating income.
(-) Interest Expense	$25	Annual Interest expense on our $500 loan @ 5%.
EBT	$99.50	Earnings before tax which is EBIT minus interest expenses.
(-) Tax Expense	$19.90	20% Corporate tax rate on our EBT.
Net Profit	$79.60	Net Profit is EBT minus our tax expenses.
Earnings Per Share	$0.796	Net Profit divided by our 100 outstanding shares.

What I look out for when reading the P/L?

When analysing an income statement, I first look at the revenue. I want to see that there is a YoY growth in sales and that the increase is stable and consistent. Increasing revenue over time is crucial for driving overall business value. If a company has a shrinking revenue base, I want to understand why and whether it’s a recurring issue or just a temporary hiccup.

Next, I take a look at expenses. I observe and monitor each of the line items across all operational expenses. I break down each item and find out what is buried within. It’s best to compare line items like SG&A or marketing costs and R&D to other companies within the same industry. Comparing a company to its peers is important. If a company is spending more than its peers, I want to know if it’s converting this additional expense into top-line revenue.

The gross margin is essential. If revenue increases but the margin shrinks, it means the company is not as efficient in managing its cost of sales.

The number one observation is whether topline revenue (customers) is converted into cash receipts on the Cash Flow Statement. Receipts are what hit the bank account and are considered paid. While an increase in revenue is fantastic, if it’s not converting to both cash receipts and a healthier bottom line, it’s of no use.

All in all, when observing the income statement, we are looking for lumpiness across all the line items. If we evaluate a business over a few years, we should be able to see consistent movements across the margins, revenue, and expenses. If there are unusual lumpy areas that stand out, we have to understand what caused this.

Gains and Losses on the Income Statement.

Gains and Losses sit at the bottom of an income statement just above Net Income. These are not core activities and so are reported separately. This section is usually a gain or loss from the sale of an asset or perhaps the unwinding of a business division. Anything that brings in a gain or a loss that is a once-off and not related to primary activity.

If it is a loss, then that would bring net income lower. If it is a gain, then it will bring up the net income. Anything that falls here as an extraordinary item should be observed, especially if it is a loss. If you are evaluating like for like year on year growth, sometimes removing these once off items can help to bring the analysis back to an even playing field. The key is to understand what was sold and whether this will impact the business operations in any way.   

Investment Ratios related to the Income Statement.

These are the most common ratios related to the Income statement. You will need the current share price to determine most of them. These are the most common ratios I use.

• Price-to-Earnings Ratio: Earnings divided by shares outstanding to find earnings per share.
• Price-to-Sales Ratio: Revenue divided by shares outstanding to find per share of revenue.
• Gross Profit Margin: Revenue minus COGS divided by Revenue.
• Operating Profit Margin: Operating Income divided by Revenue.
• Net Profit Margin: Net Income divided by Revenue.
• Interest Coverage Ratio: Operating Income divided by Interest Expenses.

➡️ Learn more about Investment Ratios.

An example of an Income Statement.

To give you an example of an Income Statement, I would like to talk about a small-cap company that I am currently observing for investment purposes. Although I won’t be revealing the company name, I can assure you that it has a strong balance sheet, a solid cash flow statement, and a very promising income statement. The company operates in a lucrative niche industry and has a simple business model that is easy to understand.

This Income Statement is a straightforward representation of key financial information that gives us a clear understanding of the company’s profitability. Although Income Statements can be complex, if I cannot understand how the business model works, how it reports its earnings, or how it derives its line items, I typically move on to another investment opportunity.

I have marked up this specific Income Statement to show you what I look for in a simple and understandable format. This particular Income Statement is very healthy, and we can see consistent increases year on year. The revenue growth is organic, consistent, and stable, with all operating expenses growing in line with top-line growth.

The company has an efficient operation that converts much of its top-line revenue into bottom-line earnings. The management is founder-led, and the financial statements are transparent, with no hidden costs or trickery. The Income Statement is presented clearly and logically, making it easy to understand the reasons behind each line item. There is no use of confusing terminologies like EBITDA or EBIT, just a clear representation of what came in, what it cost to run the business, and how much is left over for shareholders.

It would be great if all Income Statements were as simple and understandable as this one.

🚩 Red Flags to keep an eye on?

These are a list of some red flags to look out for. It does not mean the company is bad, these are prompts to dig a little deeper to understand what is happening within the business. Sometimes it is bad and means the company is in decline. Accounting is an art; the numbers tell a story. Look for these red flags and analyse whether it is likely a continuing issue or a slight hiccup. Always be vigilant and on the lookout.

Revenue Manipulation

Revenue manipulation by either making up sales figures or by reporting sales before they are made. It happens a lot more frequently than you think. It is called aggressive accounting. Look out for unusual bursts of revenue without any reasoning or changes in other line items. This is usually followed by an increase in gross profit margin. It is very hard to pinpoint fraudulent revenue reporting. Converting to cash receipts is another way to see if top line revenue is converting to cold hard cash coming in to the bank account.

Declining Revenue

Declining revenue that is sudden is a sign that something is wrong. As a company gets bigger its revenue will taper off as it captures more market share. But sudden drops in revenue need to be observed.  It could be a host of reasons, a product or service was not adopted by customers, a change in consumer taste, or a competitor eating into market share. Revenue is the driver of long-term successful companies. More revenue means more flow to the bottom-line. If revenue tapers off its not a good sign.

Declining Gross Profit

A declining Gross Profit margin is not good. This means the cost of goods sold is increasing and there will be less money left over to service all the other operational expenses. A declining Gross Profit margin can also come from lowering the prices of the products and services so customers are paying less whilst the Cost of Sales remains the same. Gross Margin is essential as the more margin a company keeps from the top line, the more can flow through to overall earnings as well as be reinvested back into the business. A tight margin does not give a company much room for anything else.

Decline in Sales and Marketing

Companies must invest in marketing and sales to attract more customers. If the marketing expense declines it may mean the opportunity to attract new customers also declines. On the reverse of this, if marketing and sales expenses increases but revenue doesn’t correlate with the increase then there is another issue there. Marketing expenses must convert to get a return.  

Rise in Share Count diluting EPS

Share dilution is another area I keep a close eye on. It means a company is raising capital by issuing more equity rather than taking on more debt. When done strategically it can be an effective way to raise capital. However, most of the time it dilutes and destroys shareholder value.  Look out for Stock-Based Compensation and excessive abuse of management issuing bonus shares to themselves. A constant rise in shares every year usually is not a good sign. It means the company is not growing organically but depending on the constant issuance of new shares. Once abused it typically keeps happening.

Tax Rate

This is another area that is more accounting trickery than successful business growth. A company may choose to change its jurisdiction purely to get a lower tax rate. Investors want hard earnings made up of sound business growth, not by moving numbers around by clever corporate structuring. If this is done for the sole purpose of lowering its tax expense it’s not a great sign. It means management is more concerned about short-term financial gimmicks than growth of the business. If the company operates and a large percentage of revenue is in a place where the tax jurisdiction is different then it can be acceptable.

Interest Expense increase

An increase in interest expenses means the company is either taking on more debt, or the interest rate has increased. A business needs to ensure it is earning enough to service its debt. This is important as if the interest costs continue to increase that eats right into the bottom line. This will usually be explained by the balance sheet and short-term or long-term debt obligations. Ideally, a company’s interest expense should decline year over year, showing it is servicing and also reducing its overall debt.

Intangible Goodwill

Goodwill is the price paid above and beyond the intrinsic value of an acquisition. This could burden a company especially if it paid too much for a company and then decides to write this off. Amortisation is usually on Goodwill. Keep a close eye on this as this can warp EBITDA significantly depending on the acquired cost of the asset. A lot of poor acquisitions have their goodwill written off.  

Look out for High other expenses

If there are large other expenses or income, then it’s key to find out why. Especially if they are one of the costs. It could be from the sale of an asset, or income from other sources not related to primary activity or core business operations. Sometimes depending on what it is we can remove the once-off-line item to not skew our year-over-year analysis.

In Summary…

Understanding how an income statement flows can be complex, but it’s important to delve deeper and comprehend other concepts, such as EBITDA, to gain a comprehensive understanding of earnings. Income statements can appear overwhelming, especially if a business has many segments, depreciation of fixed assets, goodwill, and unusual SBC that can skew results.

However, it’s not always wise to ignore them. It’s crucial to grasp how the numbers are represented and how the accounts contribute to the bottom-line earnings from the top-line sales. There may be logical explanations for write-downs and losses, and not all businesses that incur losses are bad.

The key is to answer the question “How did they arrive at this bottom-line number?” By carefully examining each line item and understanding the reasoning behind them, you can contextualise the statement and evaluate whether any irregularities are likely to reoccur or if it’s a one-off situation. Since businesses are continually evolving, the income statement is an excellent tool to assess whether a company is running, scaling, and operating efficiently and profitably.

I know there are a lot of guides on how to read an income statement, this is just some of my views on how I approach it.