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Chapter 7.16: Income Statement & its Major Components

All you need to know about income statements

Income statement is the first of the three major financial statements presented by companies in their annual reports. In this section, we will understand income statements in great detail:

  • All you need to know about income statements

    The income statement, or the statement of profit and loss, is a statement of the incomes and expenses of a company during a period. It records all these in a defined order, starting with sales revenue and eventually arriving at the net income/profit for the period. This is the portion of sales that is left behind after all other incomes for the period have been added to it and all the expanses subtracted from it.

Pro forma income statement

Accounting standards prescribe a specific structure for income statements to promote comparability. All income statements invariably start with the sales revenue for the period and end up with net income after adding some other incomes and subtracting a host of expenses from sales. The following is the pro forma structure of the income statement.

Structure of the Income Statement

Accounting standards grant companies some freedom regarding the presentation of their income statements. In most cases, companies conform to the format presented here. However, sometimes, they like to use their own conventions. This may lead to slight differences in the presentation of certain items. However, the net effect of all these on operating income, net income and EPS is always the same.We will discuss each of the components of income statements in detail in the rest of this section.

  • Major components of the income statement

  • Sales revenue: The sales revenue of a company is the product of the number of units of its output sold by it during the period and their sales price per unit. In case of routine goods, there is an inverse relationship between price and quantity produced. As one increases, the other falls. Companies therefore have to juggle between the two to achieve the optimum combination that maximizes revenue.
  • Cost of goods sold (COGS): This is the first figure to be subtracted from sales (after subtracting sales returns and excise duty) in income statements. COGS is the amount that a company spends on the production/purchase of the goods that it sells during a period. The figure we get upon the subtraction of COGS from sales is called gross profit. Naturally, companies like to keep COGS to a minimum to boost their gross profit. This can be achieved by maintaining the delicate balance between input costs and output quality. We will discuss COGS at length in the next section.
  • Operating incomes and expenses: The next category of incomes and expenses found in the incomes statement is operating incomes and expenses. This includes all the incomes and expenses that occur in the routine course of a company’s operations. Some common examples are: depreciation, amortization, rent and wages and salaries. They are all related to the company’s ‘core business’. Upon adjusting gross profit for these, we arrive at operating profit or earnings before interest and taxes (EBIT). Some companies like to combine operating incomes with sales and call it ‘total revenue from operations’. They then subtract all the operating expenses (including COGS) from it and arrive at the same figure of EBIT. This is just an accounting norm.

    They being core to its operations, companies have the hardest time reducing operating expenses. Any indiscriminate reduction in these could lead to serious consequences for the quality, quantity and price of its products. Its adverse effect on sales is not hard to imagine. The quality of management of a company is judged on the basis of its ability to reduce operating costs, without affecting a company’s operations. Operating costs normally go down as a company progresses along the experience curve and increases its scale of operations, resulting in most of these costs being shared by a larger level of output. The latter is referred to as economies of scale.

  • Depreciation and amortization: Imagine you just bought a new car. As time passes, you’ll be able to sell it for an increasingly smaller sum of money in the market. At the end of say ten years, you will receive next to nothing for it. The fall in the value of the car with each passing year is called depreciation. All tangible, long-lived assets of a company, with the exception of land, too are depreciated annually. Depreciation can be calculated using a number of methods. These include: the straight-line method- under which an equal amount is depreciated each year; the accelerated method, under which higher depreciation is charged in the initial years and it keeps tapering off thereon; and the units of production method, under which annual depreciation is charged proportionately to the units of output produced in that year. In all cases, depreciation is recorded as an expense on the income statement. Depreciation charged for intangible, long-lived assets, such as patents and copyrights, is called amortization. It is calculation and treatment in the same way as depreciation
  • Non-operating incomes and expenses: On deducting depreciation, amortization, interest on the year’s outstanding loan amount and taxes from EBITDA (earnings before interest, tax, depreciation and amortization), we arrive at profit after tax (PAT). The next category of deductions is called non-operating incomes and expenses. Non-operating items include all the incomes and expenses that are not part of the core business of the company. It is generally not a category that is explicitly mentioned on income statements. However, you may find items like profit from the sale of an old building or a non-core business, a one-time tax benefit or any other unusual incomes and expenses that are not related to the main business of the company, on the income statement. All these are non-operating items. Since they are recorded after income tax has been deducted, their values reported are net of tax. Some companies like to mention non-operating items before the deduction of income tax. In that case, their values are pre-tax and are taxed together with EBT to arrive at PAT.

    The trouble with non-operating items is their unpredictability. Since they aren’t intrinsic to a company’s business, it is hard to say when they will occur and what their value will be. For this reason, investors usually eliminate them for the assessment of income.

  • Net income: Net income is the figure we refer to when we talk about the profitability of a business in routine conversation. It is the residual figure achieved after the summation of all the incomes and deduction of all the expenses from the period’s sales. Investors are interested in this number because it forms the basis for the payment of dividends and retention for future use in the business. In either case, it is used for the benefit of shareholders. Dividend payments are directly credited to shareholders. Retention and future reinvestment leads to more income for the company in the future and an increase in the price of its shares. Companies may also use net income to buy back some of its shares from shareholders. This is another way of repaying them for their faith in the company, just like dividends. This is called share repurchase.
  • Other items: From time to time, you may also encounter some other items, such as revaluation gain/ loss, impairment gain/loss and minority interest on income statements. These may fall under operating items or may just be standalone figures. They are slightly more complex to understand and generally do not represent a large amount of money. We will therefore exclude them from our assessment.

  • Understanding inventories, COGS

    COGS is the expense incurred by a company on the production of the goods it sold during a year. It is the first major deduction from sales revenue. Expenses like cost of purchase (including taxes) and transportation of raw materials and their conversion into the final product are all included in COGS.

    COGS is closely related to inventories. A company produces its output throughout the year. Some of it is sold and the rest is left behind. The production cost of the units that are sold is reported as COGS on the income statement, while the rest is recorded as inventory balance on the balance sheet. The problem arises in deciding which units to count as a part of COGS and which as inventory. This is because the price of inputs changes throughout the year. This results in a difference in the cost of production of different units. The allocation of output to goods sold and inventory therefore has a bearing on the company’s profits.

    Four methods are commonly used for inventory valuation:

Inventory Valuation Methods

  • First-in, first-out (FIFO): Under this method, the units produced first are also considered to have been sold first. As a result, COGS is based on the production cost of older units of output, while inventory balance is based on the production cost of the more recent units of output.
  • Last-in, first-out (LIFO): This method assumes that the recently produced units of outputs were sold first and the older ones make up the inventory. LIFO is allowed only under GAAP and not under IFRS.
  • Weighted average cost: Companies that use this method calculate the total cost incurred on the production of goods throughout the year and allocate it to all the units produced. This results in the same cost for each unit, irrespective of whether it is a part of inventory or sales.
  • Specific identification: Specific identification can only be used when the specific cost of production of each unit can be calculated separately. In this case, cost of goods sold is the sum of the actual cost of production of each individual unit of output sold. Similarly, the inventory balance is the sum of the actual cost of production of each individual unit of output that remained unsold during the year.

Each method has its own impact on the profits of the company. Assuming that prices of inputs and production costs increase with time due to inflation, LIFO results in the highest COGS and smallest profits. In contrast, FIFO results in the lowest COGS and highest profits. This is because when prices increase, the cost of production of the most recent goods will be the highest and the cost of production of the oldest goods will be the lowest. Weighted average cost method is not effected by inflation at all because the same production cost is allocated to each unit of output.

  • All you need to know about EBITDA

    The relation between Net Income and EBITDA

    We discussed the calculation of EBITDA earlier. It is what remains after subtracting all the operating expenses from sales. For this reason, it is also sometimes referred to as operating income. However, technically, depreciation and amortization too have to be subtracted from EBITDA to arrive at operating income (i.e. EBIT). EBITDA is a measure of the operating efficiency of a company. It measures the amount of profit a company is able to make after incurring all the necessary expenses for the production and distribution of its goods and services. Non-operating expenses are not a part of the calculation of EBITDA. More efficient a company’s operations, lower will its operating expenses be. Consequently, for the same sales revenue, the company with the lowest operating expenses will have the highest EBITDA.

    Equity analysts sometimes prefer EBITDA over net income as a measure of profitability. This is because to arrive at net income from EBITDA, a number of other incomes and expenses have to be added and subtracted. These incomes and expenses are not a part of a company’s core operations. They occur as a consequence of other factors like the capital structure of a company, its fixed assets portfolio and the way in which it deploys its surplus funds. Net income therefore, presents a distorted picture of a company’s efficiency. EBITDA dispels these distortions by removing the contaminants of profitability, so to speak. It presents a purer picture of operational efficiency and management quality. There are three items that separate EBITDA from net income:

  • Depreciation: Depreciation is charged annually on fixed assets. More the fixed assets owned by a company and higher their value, higher will the amount of depreciation be. Depreciation expense for a given period also depends on the method of calculating depreciation that is used by a company. The difference in depreciation amounts caused by these factors is reflected in net income. When comparing companies from different sectors, depreciation amounts also differ because of the fixed asset requirement of each sector. For example, financial services companies generally require a much smaller investment in fixed assets compared to oil and gas producers. As a result, their depreciation expense is much lower than the later. This leads to a higher net income, all else held constant.
  • Non-operating incomes and expenses: Non-operating items do not form the core of a business and are not always expected to recur. Thus, companies that have big net incomes on account of high revenues or low expenses of this nature aren’t necessarily more profitable in the long run. To eliminate the impact of non-operating items on profitability assessment, it is best to make comparisons on the basis of EBITDA.
  • Interest expenses: As we will see in the section on balance sheet analysis, capital, i.e. the money required for running a business, is obtained from two principal sources- debt (including bonds) and owners’ equity. Interest expenses will be higher for companies that resort to debt to a larger extent compared to other companies. This doesn’t always mean that these companies are bad. Debt, if raised in manageable quantities, can, in fact, increase the return to shareholders. This is because more debt capital means that the company will need fewer shareholders. Each of them will, therefore, get a larger share of the company’s earnings. However, in absolute terms, higher the interest expense, lower is the net income of a company. To remove the impact of interest cost, it is best to use EBITDA instead of net income.

  • Other concepts of profit

    Apart from net income and EBITDA, investors use two other concepts of profitability for the purpose of profitability analysis- EBIT and EBT. However, just like net income these are also not completely free of contaminants. EBIT is calculated by subtracting depreciation and amortization from EBITDA. As such, it is not free from the biases imparted by the deduction of depreciation. EBT is also contaminated by differences in interest expenses of two companies in addition to depreciation. EBITDA is therefore preferred to both these. It may be noted however, that nothing mentioned in this conversation should lead you to discount the importance of profitability measures other than EBITDA. Net income provides vital information about the performance of a company. It is directly related to your dividends, as we will discover in the next segment. Also, concepts like depreciation reveal important information about the quality and age of a company’s assets. Sometimes, certain non-operating items reveal information about a company’s strategic intent. Some categories of non-operating items may recur in the case of specific companies. For example, companies that are going through a consolidation process may frequently sell strategically less important assets and business verticals. The gains/losses from the sale of these are accounted for as non-operating items. They reflect the strategic intent of the company.

  • Accounting for your dividends: Understanding EPS, diluted EPS

    If you were told that a company whose 1000 stocks you own has earned a net income of Rs.5 billion for a year, you wouldn’t learn much about its effect on your wealth. What if you were also told that the company currently has 1 billion shares outstanding? You would then be able to say that the company’s net income per share is Rs 5 (5 billion/ 1 billion). Thus, you can expect your wealth to go up by Rs.5000 (5x1000 shares) if it pays all of it as dividend. Similarly, if you were expecting a dividend of say Rs.3 per share, you can consider it to be pretty safe. This amount of Rs.5 is called a company’s earnings per share or EPS. EPS is calculated by dividing net income by the number of shares of a company that are currently outstanding. It tells one exactly how much money per share a company has made and what amount one could expect as dividend. You can then comment on whether your dividend expectations can be met or not.

    You will normally find two kinds of EPS in an annual report- basic and diluted. What we just calculated is basic EPS. Sometimes companies issue complex investment products such as warrants and convertibles. These allow their buyer to convert them into shares of the company at a definite point in the future. Companies also provide their employees the option of receiving a fixed quantity of its shares as compensation in the future, at a time of their choice. This is called employee stock options (ESOPs). The combined effect of the exercise of these privileges is an increase in the number of shares of the company. This increase will lead to a decrease in the company’s EPS. The EPS calculated after including these new shares in the calculation is called diluted EPS.

What next?

Incomes reported on the income statements are both on cash and accrual basis. Accruals don’t tell us much about the earnings potential of a company. We are more concerned about the cash it has managed to earn during a period. In the next section, we will discuss the cash flow statement, which is the second important financial statement published by companies. It accounts for the movement of cash in and out of a business during a year.

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