The Income Statement.

**xxyygorich** Sun May 14, 2006 5:25 pm

The Income Statement.
Last week, I talked about the simplest form of the balance sheet.
See here
http://value-investing-forum.com/viewtopic.php?t=984

This week, I'd like to talk about another important financial statement of a business, the income statement.

Code:
Income Statement Format

Net Sales A
Cost of Goods B
-------------------------------------------
Gross Margin C = A - B

Sales & Marketing D
Research & Development E
General & Administrative F
-------------------------------------------
Operating Expenses G = D + E + F

Income from Operation H = C - G

Interest Income I
Income Tax J

Net Income K = H + I - J
============================================

Key formula

The Income Statement reports on making and selling activities of a business over a period of time. The Income Statement represents the second basic accounting equation:
Code:
Sale - Cost & Expenses = Income.

The income statement gives one important perspective on the health of a business -- its profitability. However, it can not tell u the whole picture of a business, it says nothing about when the company receives cash or how much cash it has on hand.

Explanation of the Income Statement
A. Net Sales.
When a product is shipped, a sale is booked. Net sales is the total amount the company will ultimately collect from a sale, which is the list price less all discounts offered.
"Sales" and "Revenues" do mean the same thing.
B. Cost of Goods.
The total cost of manufacturing the products.
When the company made the product, it took all the product's costs and added them to the value of inventory. Upon the sale, these cost are record as "cost of goods sold".
C. Gross Margin.
Or gross profit, manufacturing margin.
G. Operating Expenses.
Those expenditures that a company makes to generate income, also called "SG&A" expenses.
Difference of "Cost" and "Expense"
Cost: Manufacturing expenditures to build inventory.
Expenses: all other business expenditures.
H. Income from operations
Income can be also generated from from financial (non-operating) activities.
The terms "income", "profit" and "earnings" all have the same meaning, which represents the following formula:
Code: Income = Sale - (Cost + Expense)
I,J. Non-operating Income and Expense
A company's operation can be producing income (profit) but the company as a whole can still show an overall loss, which is caused by high non-operating expenses (such as high interest expenses).
K. Net Income
Income is NOT cash. A very profitable company wiht lots of net income can also be insolvent, that is with no cash left to pay its bill.

The Income Statement and the Balance Sheet
The income statement and the balance sheet are closely linked.
Income statement => Income (profit) => retained earnings are increased on the balance sheet. => Either the assets will increase or the liabities will decrease for the balance sheet to remain in balance.

Combine information the Income Statement and the Balance Sheet

Code:
Profit Margin (Return on Sale) = Net Income / Net Sale = K / A

Gross Margin = (Net Sales - COGS) / Net Sale = (A - B) / A

These two ratios can be used to compare different competitors in the same inductry section. The ratio from different industry might have huge difference, ex. retail businesses generally have a gross margin of 25%, Computer software business can have 80-90% gross profit.

Code:
Return on Assets (ROA) = Net Income / Total Assets = K / J (in the Balance Sheet.)

Return on Equity (ROE or ROI) = Net Income / Shareholders' Equity = K / S (in the Balance Sheet.)

These two ratios are very important to evaluate the performance of management's success.

Reference.
Financial Statements, a step by step guide to understanding and creating Financial reports. Ittelson, Thomas, 1998