Chapter 7

Using the Income Statement

In This Chapter

Getting acquainted with the income statement

Considering different types of revenue

Determining a company's expenses

Analyzing a company's finances using profits and losses

Figuring out earnings per share

Every business person needs to know how well his business has done over the past month, quarter, or year. Without that information, he has no idea where his business has come from and where it may go next. Even a small business that has no obligation to report to the public is sure to do income statements on at least a quarterly or (more likely) monthly basis to find out whether the business made a profit or took a loss.

The income statement you see in public financial statements is likely very different from the one you see if you work for the company. The primary difference is the detail in certain line items.

In this chapter, I review the detail that goes into an income statement, but don't be surprised if some of the detail never shows up in the financial reports you get as a company outsider. Much of the detail is considered confidential and doesn't go to people outside the company. I include this detailed information in this chapter so you know what's behind the numbers you do see. If you're a company insider, this additional information can help you understand the internal reports you receive.

Introducing the Income Statement

The income statement is where you find out whether a company made a profit or took a loss. You also find information about the company's revenues, its sales levels, the costs it incurred to make those sales, and the expenses it paid to operate the business. These are the key parts of the statement:

• Sales or revenues: How much money the business took in from its sales to customers.
• Cost of goods sold: What it cost the company to produce or purchase the goods it sold.
• Expenses: How much the company spent on advertising, administration, rent, salaries, and everything else that's involved in operating a business to support the sales process.
• Net income or loss: The bottom line that tells you whether the company made a profit or operated at a loss.

The income statement is one of the three reports the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) require; I describe their roles in the preparation of financial statements in Chapters 18 and 19. In fact, the FASB specifies that the income statement provide a report of comprehensive income, which means the report must reflect any changes to a company's equity during a given period of time that are caused by transactions, events, or other circumstances involving transactions with nonowner sources. In simpler terms, this statement must reflect any changes in equity that aren't raised by investments from owners or distributed to owners.

When looking at an income statement, you can expect to find a report of either

• Excess of revenues over expenses: This report means the company earned a profit.
• Excess of expenses over revenues: This report means the company faced a loss.

Because the income statement shows profits and losses, some people like to call it the profit and loss statement (or P&L), but that isn't actually one of its official names. In addition to “statement of income,” the income statement has a number of official names that you may find in a financial report:

• Statement of operations
• Statement of earnings
• Statement of operating results

Digging into dates

Income statements reflect an operating period, which means that they show results for a specific length of time. At the top of an income statement, you see the phrase “Years Ended” or “Fiscal Years Ended” and the month the period ended for an annual financial statement. You may also see “Quarters Ended” or “Months Ended” for reports based on shorter periods of time. Companies are required to show at least three periods of data on their income statements, so if you're looking at a statement for 2012, you also find columns for 2011 and 2010.

Many people believe you need to analyze at least five years’ worth of data if you're thinking about investing in a company. You can easily get hold of this data by ordering a two-year-old annual report along with the current one. You can also find most annual and quarterly reports online at a company's website or by visiting the SEC's Edgar website (www.sec.gov/edgar.shtml), which posts all financial reports filed with the SEC. Because each report must have three years’ worth of data, a 2012 report shows data for 2011 and 2010, too. And a 2009 report shows 2008 and 2007 data also. So you actually have six years’ worth of data with these reports: 2012, 2011, 2010, 2009, 2008, and 2007.

Figuring out format

Not all income statements look alike. Basically, companies can choose to use one of two formats for the income statement: the single-step or the multistep.

Both formats give you the same bottom-line information. The key difference between them is whether they summarize that information to make analyzing it easier. The single-step format is easier to produce, but the multistep format gives you a number of subtotals throughout the statement that make analyzing a company's results easier. Most public corporations use the multistep format, but many smaller companies that don't have to report to the general public use the single-step format.

Single-step format

The single-step format groups all data into two categories: revenue and expenses. Revenue includes income from sales, interest income, and gains from sales of equipment. It also includes income that a company raises from its regular operations or from one-time transactions, such as from the sale of a building. Expenses include all the costs that are involved in bringing in the revenue.

The single-step format (see Figure 7-1) gets its name because you perform only one step to figure out a company's net income — you subtract the expenses from the revenue.

Multistep format

The multistep format divides the income statement into several sections and gives the reader some critical subtotals that make analyzing the data much easier and quicker. Even though the single-step and multistep income statements include the same revenue and expense information, they group the information differently. The key difference is that the multistep format has the following four profit lines:

• Gross profit: This line reflects the profit generated from sales minus the cost of the goods sold.
• Income from operations: This line reflects the operating income the company earned after subtracting all its operating expenses.
• Income before taxes: This line reflects all income earned — which can include gains on equipment sales, interest revenue, and other revenue not generated by sales — before subtracting taxes or interest expenses.
• Net income (or Net loss): This line reflects the bottom line — whether the company made a profit.

Many companies add even more profit lines, like earnings before interest, taxes, depreciation, and amortization, known as EBITDA for short (see the section “EBITDA,” later in this chapter).

Some companies that have discontinued operations include that information in the line item for continuing operations. But it's better for the financial report reader if that information is on a separate line; otherwise, the reader doesn't know what the actual profit or loss is from continuing operations. I delve a bit deeper into these various profit lines in “Sorting Out the Profit and Loss Types,” later in this chapter.

Figure 7-2 shows the multistep format, using the same items as in the single-step format example (refer to Figure 7-1).

Delving into the Tricky Business of Revenues

You may think that figuring out when to count something as revenue is a relatively simple procedure. Well, forget that. Revenue acknowledgment is one of the most complex issues on the income statement. In fact, you may have noticed that, with the recent corporation scandals, the most common reason companies have gotten into trouble has to do with the issue of misstated revenues.

In this section, I define revenue and explain the three line items that make up the revenue portion of the income statement: sales, cost of goods sold, and gross profit.

Defining revenue

When a company recognizes something as revenue, it doesn't always mean that cash changed hands, nor does it always mean that a product was even delivered. Accrual accounting leaves room for deciding when a company actually records revenue. A company recognizes revenue when it earns it and recognizes expenses when it incurs them, without regard to whether cash changes hands. You can find out more about accounting basics in Chapter 4.

Because accrual accounting doesn't require that a company actually have the cash in hand to count something as revenue, senior managers can play games to make the bottom line look the way they want it to look by either counting or not counting income. Sometimes they acknowledge more income than they should to improve the financial reports; other times they reduce income to reduce the tax bite. I talk more about these shenanigans in Chapter 23.

When a company wants to count something as revenue, several factors can make that decision rather muddy, leaving questions about whether a particular sale should be counted:

• If the seller and buyer haven't agreed on the final price for the merchandise and service, the seller can't count the revenue collected.

  For example, when a company is in the middle of negotiating a contract for a sale of a major item such as a car or appliance, it can't include that sale as revenue until the final price has been set and a contract obligating the buyer is in place.

• If the buyer doesn't pay for the merchandise until the company resells it to a retail outlet (which may be the case for a company that works with a distributor) or to the customer, the company can't count the revenue until the sale to the customer is final.

  For example, publishers frequently allow bookstores to return unsold books within a certain amount of time. If there's a good chance that some portion of the product may be returned unsold, companies must take this into account when reporting revenues. For instance, a publisher uses historical data to estimate what percentage of books will be returned and adjusts sales downward to reflect those likely returns.

• If the buyer and seller are related, revenue isn't acknowledged in the same way.

  No, I'm not talking about kissing cousins here. I'm talking about when the buyer is the parent company or subsidiary of the seller. In that case, companies must handle the transaction as an internal transfer of assets.

• If the buyer isn't obligated to pay for the merchandise because it's stolen or physically destroyed before it's delivered or sold, the company can't acknowledge the revenue until the merchandise is actually sold.

  For example, a toy company works with a distributor or other middleman to get its toys into retail stores. If the middleman doesn't have to pay for those toys until they're delivered or sold to retailers, the manufacturer can't count the toys it shipped to the middleman as revenue until the middleman completes the sale.

• If the seller is obligated to provide significant services to the buyer or aid in reselling the product, the seller can't count the sale of that product as revenue until the sale is actually completed with the final customer.

  For example, many manufacturers of technical products offer installation or follow-up services for a new product as part of the sales promotion. If those services are a significant part of the final sale, the manufacturer can't count that sale as revenue until the installation or service has been completed with the customer. Items shipped for sale to local retailers under these conditions aren't considered sold, so they can't be counted as revenue.

Adjusting sales

Not all products sell for their list price. Companies frequently use discounts, returns, or allowances to reduce the prices of products or services. Whenever a firm sells a product at a discount, it needs to keep track of those discounts, as well as its returns and allowances. It's the only way the company can truly analyze how much money it's making on the sale of its products and how accurately it's pricing the products to sell in the marketplace.

If a company must offer too many discounts, it's usually a sign of a weak or very competitive market. If a company has a lot of returns, it may be a sign of a quality-control problem or a sign that the product isn't living up to customers’ expectations. The sales adjustments I talk about here help a company track and analyze its sales and recognize any negative trends.

As a financial report reader, you don't see the specifics about discounts in the income statement, but you may find some mention of significant discounting in the notes to the financial statements. Here are the most common types of adjustments companies make to their sales:

• Volume discounts: To get more items in the marketplace, manufacturers offer major retailers volume discounts, which means these retailers agree to buy a large number of a manufacturer's product so they can save a certain percentage of money off the price. One of the reasons you get such good prices at discount sellers like Wal-Mart and Target is that they buy products from the manufacturer at greatly discounted prices. Because they purchase for thousands of stores, they can buy a large number of goods at one time. Volume discounts reduce the revenue of the company that gives them.
• Returns: Returns are arrangements between the buyer and seller that allow the buyer to return goods for a number of reasons. I'm sure you've returned goods that you didn't like, that didn't fit, or that possibly didn't even work. Returns are subtracted from a company's revenue.
• Allowances: Gift cards and other accounts that a customer pays for up front without taking merchandise are types of allowances. Allowances are actually liabilities for a store because the customer hasn't yet selected the merchandise and the sale isn't complete. Revenues are collected up front, but at some point in the future, merchandise will be taken off the shelves and the company won't receive additional cash.

Most companies don't show you the details of their discounts, returns, and allowances, but they do track them and adjust their revenue accordingly. When you see a net sales or net revenue figure (the company's sales minus any adjustments) at the top of an income statement, the company has already adjusted the figure for these items.

Internally, managers see the details of these adjustments in the sales area of the income statement so that they can track trends for discounts, returns, and allowances. Tracking such trends is an important aspect of the managerial process. If a manager notices that any of these line items show a dramatic increase, she needs to investigate the reason for the increase. For example, an increase in discounts may mean that the company has to consistently offer its products for less money, which then may mean that the market is softening and fewer customers are buying fewer products. A dramatic increase in returns may mean that the products the business is selling have a defect that needs to be corrected.

Considering cost of goods sold

Like the Sales line item, the Cost of goods sold (what it costs to manufacture or purchase the goods being sold) line item has many different pieces that make up its calculation on the income sheet. You don't see the details for this line item unless you're a company manager. Few firms report the details of their cost of goods sold to the general public.

Items that make up the cost of goods sold vary depending on whether a company manufactures the goods in-house or purchases them. If the company manufactures them in-house, you track the costs all the way from the point of raw materials and include the labor involved in building the product. If the company purchases its goods, it tracks the purchases of the goods as they're made.

In fact, a manufacturing firm tracks several levels of inventory, including

• Raw materials: The materials used for manufacturing
• Work-in-process inventory: Products in the process of being constructed
• Finished-goods inventory: Products ready for sale

Sometimes tracking begins from the time the raw materials are purchased, with adjustments based on discounts, returns, or allowances given. Companies also add to the income statement's cost of goods sold section freight charges and any other costs involved directly in acquiring goods to be sold.

When a company finally sells the product, it becomes a Cost of goods sold line item. Managing costs during the production phase is critical for all manufacturing companies. Managers in this type of business receive regular reports that include the cost details. Trends that show dramatically increasing costs certainly must be investigated as quickly as possible because the company must consider a price change to maintain its profit margin.

Even if a company is only a service company, it likely has costs for the services it provides. In this case, the line item may be called Cost of services sold instead of Cost of goods sold. You may even see a line item called Cost of goods or services sold if a company gets revenue from the sale of both goods and services.

Gauging gross profit

The Gross profit line item in the income statement's revenue section is simply a calculation of net revenue or net sales minus the cost of goods sold. Basically, this number shows the difference between what a company pays for its inventory and the price at which it sells this inventory. This summary number tells you how much profit the company makes selling its products before deducting the expenses of its operation. If the company shows no profit or not enough profit here, it's not worth being in business.

Managers, investors, and other interested parties closely watch the trend of a company's gross profit because it indicates the effectiveness of the company's purchasing and pricing policies. Analysts frequently use this number not only to gauge how well a company manages its product costs internally, but also to gauge how well the firm manages its product costs compared with other companies in the same business.

If profit is too low, a company can do one of two things: find a way to increase sales revenue or find a way to reduce the cost of the goods it's selling.

To increase sales revenue, the company can raise or lower prices to increase the amount of money it's bringing in. Raising the prices of its product brings in more revenue if the same number of items is sold, but it may bring in less revenue if the price hike turns away customers and fewer items are sold.

Lowering prices to bring in more revenue may sound strange to you, but if a company determines that a price is too high and is discouraging buyers, doing so may increase its volume of sales and, therefore, its gross margin. This scenario is especially true if the company has a lot of fixed costs (such as manufacturing facilities, equipment, and labor) that it isn't using to full capacity. The firm can use its manufacturing facilities more effectively and efficiently if it has the capability to produce more product without a significant increase in the variable costs (such as raw materials or other factors, like overtime).

A company can also consider using cost-control possibilities for manufacturing or purchasing if its gross profit is too low. The company may find a more efficient way to make the product, or it may negotiate a better contract for raw materials to reduce those costs. If the company purchases finished products for sale, it may be able to negotiate better contract terms to reduce its purchasing costs.

Acknowledging Expenses

Expenses include the items a company must pay for to operate the business that aren't directly related to the sale and production of specific products. Expenses differ from the cost of goods sold, which can be directly traced to the actual sale of a product. Even when a company is making a sizable gross profit, if management doesn't carefully watch the expenses, the gross profit can quickly turn into a net loss.

Expenses make up the second of the two main parts of the income statement; revenues make up the first part.

Advertising and promotion, administration, and research and development are all examples of expenses. Although many of these expenses impact the ability of a company to sell its products, they aren't direct costs of the sales process for individual items. The following are details about the key items that fit into the expenses part of the income statement:

• Advertising and promotion: For many companies, one of the largest expenses is advertising and promotion. Advertising includes TV and radio ads, print ads, and billboard ads. Promotions include product giveaways (hats, T-shirts, pens with the company logo on it, and so on) or name identification on a sports stadium. If a company helps promote a charitable event and has its name on T-shirts or billboards as part of the event, it must include these expenses in the Advertising and promotion expense line item.
• Other selling administration expenses: This category is a catchall for any selling expenses, including salespeople's and sales managers’ salaries, commissions, bonuses, and other compensation expenses. The costs of sales offices and any expenses related to those offices also fall into this category.
• Other operating expenses: If a company includes line-item detail in its financial reports, you usually find that detail in the notes to the financial statements. All operating expenses that aren't directly connected to the sale of products fall into the category of other operating expenses, including these expenses:
  • General office needs: Administrative salaries and expenses for administrative offices, supplies, machinery, and anything else needed to run the general operations of a company are reported in general office needs. Expenses for human resources, management, accounting, and security also fall into this category.
  • Royalties: Any royalties (payments made for the use of property) paid to individuals or other companies fall under this umbrella. Companies most commonly pay royalties for the use of patents or copyrights that another company or individual owns. Companies also pay royalties when they buy the rights to extract natural resources from another person's property.
  • Research and product development: This line item includes any costs for developing new products. Most likely, you find details about research and product development in the notes to the financial statements or in the managers’ discussion and analysis. Any company that makes new products has research and development costs because if it isn't always looking for ways to improve its product or introduce new products, it's at risk of losing out to a competitor.
• Interest expenses: This line item shows expenses paid for interest on long- or short-term debt. You usually find some explanation for the interest expenses in the notes to the financial statements.
• Interest income: If a company receives interest income for any of its holdings, you see it in this line item. This category includes notes or bonds that the company holds, such as marketable securities, or interest paid by another company to which it loaned short-term cash.
• Depreciation and amortization expenses: Depreciation on buildings, machinery, or other items, as well as amortization on intangible items, fall into this line item. You have to look in the notes to the financial statements to find more details on depreciation and amortization. To discover how these expenses are calculated, see Chapter 4.
• Insurance expenses: In addition to insurance expenses for items such as theft, fire, and other losses, companies usually carry life insurance on their top executives and errors and omissions insurance for their top executives and board members. Errors and omissions insurance protects executives and board members from being sued personally for any errors or omissions related to their work for the company or as part of their responsibility on the company's board.
• Taxes: All corporations have to pay income taxes. In the taxes category, you find the amount the company actually paid in taxes. Many companies and their investors complain that corporate income is taxed twice — once directly as a corporation and a second time on the dividends that the shareholders receive. In reality, many corporations can use so many tax write-offs that their tax bill is zero or near zero.
• Other expenses: Any expenses that don't fit into one of the earlier line items in this list fall into this category. What goes into this category varies among companies, depending on what each company chooses to show on an individual line item and what it groups in other expenses. However, a firm doesn't include expenses relating to operating activities in this category; those expenses go on the line item for other operating expenses. Companies separate operating expenses from nonoperating expenses.

Sorting Out the Profit and Loss Types

When you hear earnings or profits reports on the news, most of the time, the reporters are discussing the net profit, net income, or net loss. For readers of financial statements, that bottom-line number doesn't tell the entire story of how a company is doing. Relying solely on the bottom-line number is like reading the last few pages of a novel and thinking that you understand the entire story. All you really know is the end, not how the characters got to that ending.

Because companies have so many different charges or expenses unique to their operations, different profit lines are used for different types of analysis. I cover the types of analysis in Part III, but in this section, I review what each of these profit types includes or doesn't include. For example, gross profit is the best number to use to analyze how well a company is managing its sales and the costs of producing those sales, but gross profit gives you no idea how well the company is managing the rest of its expenses.

Using operating profits, which show you how much money a company made after considering all costs and expenses for operating, you can analyze how efficiently the company is managing its operating activities, but you don't get enough detail to analyze product costs.

EBITDA

A commonly used measure to compare companies is earnings before interest, taxes, depreciation, and amortization, also known as EBITDA. With this number, analysts and investors can compare profitability among companies or industries because it eliminates the effects of the companies’ activities to raise cash outside their operating activities, such as by selling stock or bonds. EBITDA also eliminates any accounting decisions that may impact the bottom line, such as the companies’ policies relating to depreciation methods.

Investors reading the financial report can use this line item to focus on the profitability of each company's operations. If a company does include this line item, it appears at the bottom of the expenses section but before line items listing interest, taxes, depreciation, and amortization.

How a firm chooses to raise money can greatly impact its bottom line. Selling equity has no annual costs if dividends aren't paid. Borrowing money means interest costs must be paid every year, so a company will have ongoing required expenses.

EBITDA gives financial report readers a quick view of how well a company is doing without considering its financial and accounting decisions. This number became popular in the 1980s, when leveraged buyouts were common. A leveraged buyout takes place when an individual or company buys a controlling interest (which means more than 50 percent) in a company, primarily using debt (up to 70 percent or more of the purchase price). This fad left many businesses in danger of not earning enough from operations to pay their huge debt load.

Today EBITDA is frequently touted by technology companies or other high-growth companies with large expenses for machinery and other equipment. In these situations, the companies like to discuss their earnings before the huge write-offs for depreciation, which can make the bottom line look pretty small. Be aware that a company can use EBITDA as an accounting gimmick to make earnings sound better to the general public or to investors who don't take the time to read the fine print in the annual report.

Firms can get pretty creative when it comes to their income statement groupings. If you don't understand a line item, be sure to look for explanations in the notes to the financial statements. If you can't find an explanation there, call investor relations and ask questions.

Nonoperating income or expense

If a company earns income from a source that isn't part of its normal revenue-generating activities, it usually lists this income on the income statement as nonoperating income. Items commonly listed here include the sale of a building, manufacturing facility, or company division. Other types of nonoperating income include interest from notes receivable and marketable securities, dividends from investments in other companies’ stock, and rent revenue (if the business subleases some of its facilities).

Companies also group one-time expenses in the nonoperating section of the income statement. For example, the severance and other costs of closing a division or factory appear in this area, or, in some cases, the statement has a separate section on discontinuing operations. Other types of expenses include casualty losses from theft, vandalism, or fire; loss from the sale or abandonment of property, plant, or equipment; and loss from employee or supplier strikes.

You usually find explanations for income or expenses from nonoperating activities in the notes to the financial statements. Companies need to separate these nonoperating activities; otherwise, investors, analysts, and other interested parties can't gauge how well a company is doing with its core operating activities. The Core operating activities line item is where you find a company's continuing income. If those core activities aren't raising enough income, the firm may be on the road to significant financial difficulties.

A major gain may make the bottom line look great, but it can send the wrong signal to outsiders, who may then expect similar earnings results the next year. If the company doesn't repeat the results the following year, Wall Street will surely hammer its stock. A major one-time loss also needs special explanation so that Wall Street doesn't downgrade the stock unnecessarily if the one-time nonoperating loss won't be repeated in future years.

Whether a gain or a loss, separating nonoperating income from operating income and expenses helps avoid sending the wrong signal to analysts and investors about a company's future earnings and growth potential.

Net profit or loss

The bottom line of any income statement is net profit or loss. This number means little if you don't understand the other line items that make up the income statement. Few investors and analysts look solely at net profit or loss to make a major decision about whether a company is a good investment.

Calculating Earnings per Share

In addition to net income, the other number you hear almost as often about a company's earnings results is earnings per share. Earnings per share is the amount of net income the company makes per share of stock available on the market. For example, if you own 100 shares of stock in ABC Company and it earns $1 per share, $100 of those earnings are yours unless the company decides to reinvest the earnings for future growth. In reality, a company rarely pays out 100 percent of its earnings; it usually pays out a small fraction of those earnings.

You find the calculation for earnings per share on the income statement after net income, or in a separate statement called the statement of shareholders’ equity. The calculation for earnings per share is relatively simple: You divide the net earnings or net income (which you find on the income statement) by the number of outstanding shares (which you can find on the balance sheet).

Basically, earnings per share shows you how much money each shareholder made for each of her shares. In reality, this money doesn't get paid back to the shareholder. Instead, most is reinvested in future operations of the company. The net income or loss is added to the retained earnings number on the balance sheet.

Any dividends declared per share appear on the income statement under the earnings per share information. You find the amount of dividends paid on the statement of cash flows, which I talk about in Chapter 8. The company's board of directors declares dividends either quarterly or annually.

At the bottom of an income statement, you see two numbers:

• The basic earnings per share is a calculation based on the number of shares outstanding at the time the income statement is developed.
• The diluted earnings per share includes other potential shares that may eventually be outstanding. This category includes shares designated for items like stock options (options companies give to employees to buy shares of stock at a set price, usually lower than the market price), warrants (shares of stock companies promise to bondholders or preferred shareholders for additional shares of stock at a set price, usually below the stock's market value), and convertibles (shares of stock companies promise to a lender who owns bonds that are convertible to stock).

These numbers give you an idea of how much a company earns per share. You can use them to analyze the company's profitability, which I show you how to do in Chapter 11.