books about online stock trading, forex, futures, stock investing, market, trading systems
The Income Statement
Back to contents page

Now that we know how much a company owns and how much it owes, we can move on to the good stuff—how much money it's making (or losing.) In a IO-K, you'll usually see the income statement labeled as the "consolidated statement of income" or the "consolidated statement of earnings".The Income Statement

Revenue

Sometimes labeled "sales," this is simply how much money the company has brought in during a quarter or a year. Larger companies sometimes break down revenues on the income statement according to business sector, geographic region, or products versus services.

Be sure to check the "revenue recognition policies" buried in the financial statements so you know what you're looking at—companies can record rev­enue at different times depending on the business that they're in. A software firm, for example, might record a big chunk of revenue when a product is

Figure 5.9 ACME Corporation's income statement. Source: Morningstar, Inc.

shipped to a customer, whereas a service firm might record revenue smoothly over the life of the service contract.

Cost of Sales

Also known as cost of goods sold, this number represents the expenses most di­rectly involved in creating revenue, such as labor costs, raw materials (for manufacturers), or the wholesale price of goods (for retailers). Large companies that combine manufacturing with services (H-P, for example) sometimes break down this number into cost of goods sold and cost of services.

Gross Profit

This doesn't appear on all income statements, but it's simply revenue minus cost of sales. Once you have gross profit, you can calculate a gross margin, "which is gross profit as a percentage of revenue. Essentially, this tells you how much a company is able to mark up its goods. As you can see in Figure J.io, Dell has a gross margin of only 17.9 percent ($6.3 billion in gross profit divided by S35.4 billion in sales) because it sells commodity products. It's tough for Dell to charge much of a premium for the computers it sells.

H-P, meanwhile, sells higher end computer gear for which its customers are more willing to pay up. If you look at Figure 5.11, you can see this in its gross margin: Take product revenue of $45.9 billion, subtract product costs of $34.6 billion, and we have a gross profit of $11.4 billion. Divide that back into revenue, and we're left with a gross margin of 24.8 percent. As you can see, the more differentiated a company's products are, the more it can mark up its goods over what it costs to manufacture them. H-P also bundles proprietary software with a lot of the computers it sells, and software has very high gross margins.

Selling, General, and Administrative Expenses (SG8A)

This number, also known as operating expenses, includes items such as marketing, administrative salaries, and, sometimes, research and development.

Figure 5.10 Dell's partial income statement. Source: Dell SEC filings.

Figure 5.11 Hewlett-Packard's partial income statement. Source: Hewlett-Packard SEC filings.

(Research and development is usually broken out as a separate line item, as is marketing for firms that spend large amounts on advertising.) You'll often see a relationship between SG&A and gross margin—firms that are able to charge more for their goods (e.g., H-P) have to spend more on salespeople and marketing. You can get a feel for how efficient a firm is by looking at SG&A as a percentage of revenues—a lower percentage of operating expenses relative to sales generally means a tighter, more cost-effective firm.

H-P, for example (see Figure 5.12), spent about 16 percent—or $9 billion— of its $56.5 billion in revenue on SG&A, whereas Dell spent only 8.9 percent of revenue on these types of costs.

Some of the difference results from the fact that Dell sells direct to cus­tomers and H-P has to pay salespeople to sell big-ticket computers to large corporations, but it still looks as though Dell runs a leaner shop than H-P.

Unfortunately, it's tough to give any hard-and-fast rules as to just how much a company should be spending on SG&A. Your best bet is to compare a company with its closest competitors to see which is able to do more with less and to look at SG&A as a percentage of sales over time. (If it's rising fast, watch out—the firm is spending more on overhead without reaping the benefit of higher sales.)

Figure 5.12 Dell and Hewlett-Packard's partial income statements. Source: Dell/Hewlett-Packard SEC filings.

Depreciation and Amortization

When a company buys an asset intended to last a long time, such as a new building or a piece of machinery, it charges off a portion of the cost of that asset on its income statement over a series of years. (Think back to Mike's grilling tongs.) This number is occasionally broken out separately on the income statement, but it's usually rolled into operating expenses. It's always included in the cash flow statement, though, so you can look there to see how much a company's net Income was affected by noncash charges such as depreciation.

Nonrecurring Charges/Gains

This is the catch-all area where companies put all the one-time charges or gains that aren't part of their regular, ongoing operations, such as the cost of closing a factory or the gain from selling a division. Ideally, you'd want to see this area of the income statement blank most of the time.

You should view one-time expenses with a great deal of skepticism. Companies have gotten into the habit of rolling many costs that really are part of doing business into charges, and firms that are serial chargers —meaning that they seem to take some kind of hit every year—are much more difficult to analyze because all kinds of expenses can be burled In one-time charges. The reasons behind these charges are always detailed in the notes section of a firm's financial statements, which you should certainly read to understand what caused the charges.

As you can see in Figure 5.13, H-P took a $1.8 billion charge in 2OO2 for restructuring, a $793 million charge for "in process research and development," and another $700 million in other assorted charges related to its merger with Compaq. Although a merger of this size doesn't occur every day, which means we can cut H-P some slack, we can also see that H-P had a good-sized restructuring charge of $384 million in 2001. If I owned H-P, I'd want to look very carefully at all of those charges to make sure they really were nonrecurring because serial charging is a sign of bad faith on management's part.

Operating Income

This number is equal to revenues minus cost of sales and all operating expenses. Theoretically, it represents the profit the company made from its actual operations, as opposed to interest income, one-time gains, and so forth. In practice, companies often include nonrecurring expenses (such as write-offs) in figuring operating income, and you have to add back one-time charges (or subtract one-time gains) yourself.

Operating income is as close to a solid bottom-line number as you're going to get for most firms. Because it excludes most one-time items, as well as income from nonoperatlonal sources such as investments, you can use it to calculate an operating margin, which Is fairly comparable across firms and across industries.

Figure 5.13 Hewlett-Packard's partial income statement. Source: Hewlett-Packard SEC filings.

Sometimes interest income and interest expense are listed separately, and sometimes they are combined into net interest income (or expense, as the case may be). In either case, this number represents interest the company has paid on bonds it has issued or received on bonds or cash that it owns. You can get some insight into the financial health of a firm by looking at its earnings before interest and taxes relative to its interest expense, which is called an interest coverage ratio. This tells you the extent to which a firm's profits can cover needed interest payments. I talk more about such financial-health measures in the next chapter.

Taxes

Uncle Sam has to get paid, and tax information is usually the last expense listed before net income. Unfortunately, corporate taxation is an extremely complex topic because companies submit a completely separate set of financial state­ments to the IRS for tax purposes than the ones you and I see filed with the SEC. (There are a whole host of reasons for this—the biggest cause is different depreciation schedules—but it's not something you need to worry about.)

In general, the tax rate for U.S. corporations is around 35 percent. If the tax rate for a company you're analyzing is much lower than this, find out why, and find out whether that tax advantage is likely to be permanent or tempo­rary. Some firms get tax breaks because they're located outside the United States , even if the bulk of their sales are made here in the States.

In addition, look at the tax rate of the firm you're analyzing over time. If it bounces around from year to year, the firm may be generating earnings by playing with tax loopholes rather than selling more goods or services. Tax ad­vantages are nice to have, but politicians have a bad habit of taking them away at inopportune times, so it's not money you want to necessarily count on.

Net Income

This number represents (at least theoretically) the company's profit after all expenses have been paid, and it's the number most companies highlight in their quarterly earnings releases. As we saw in the Mike's hot dog example, net income may or may not be a good representation of the amount of cash the company has generated. For that, we'll need to look at the statement of cash flows. Although net income is the number you'll most often see com­panies tout in their press releases, don't forget that it can be wildly distorted by one-time charges and/or investment income.

Number of Shares (Basic and Diluted)

This figure represents the number of shares used in calculating earnings per share; it represents the average number of shares outstanding during the reporting period (a quarter or a year). Basic shares include only actual shares of stock, and you should pretty much ignore it—the fact that it's still recorded in financial statements is more of a historical legacy than anything else.

Diluted shares, however, include securities that could potentially be converted into shares of stock, such as stock options and convertible bonds. Given the amount of egregious granting of stock options that has occurred over the past several years, it's the diluted number that you'll want to look at, because you want to know the degree to which your stake in the firm could potentially be shrunk (or diluted) if all those option-holders convert their op­tions into shares.

You can see in Figure 5,14 that H-P's basic and diluted shares are the same but that Dell has about 2 percent more diluted shares. Because diluted shares can be as much as 5 percent or more higher than basic shares, that's not a huge amount of dilution.

Earnings per Share (Basic and Diluted)

This number, which represents net Income divided by number of shares, usually gets the most attention when a company reports its quarterly or annual results. It's not the end-all, be-all of corporate financial performance, though—in fact, without looking at cash flow and many other factors, it's mostly meaningless. So when you read in the paper that a firm "beat" or "missed" earnings per share estimates, don't get excited. Find out why instead.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading