The First Financial Statement to Understand - The Income Statement

Today, we can easily buy and sell stocks using our smartphones. But before buying a stock, there is something important to understand: how much money the company is making. How can we tell whether a company is doing well financially? One way is to examine its financial statements. Financial statements are reports that summarize a company's financial condition and business performance using numbers. Just as a medical checkup helps us understand our health, financial statements help investors understand the financial health of a company. There are several types of financial statements, but one of the best places to start is the income statement. An income statement shows how much revenue a company generated, how much it spent, and how much profit it earned over a specific period. Companies generally prepare income statements for periods such as three months or one year. Imagine that you own a small coffee company. Over one year, your company generates $100,000 from selling coffee. The money a company earns from selling its products or services is called revenue. Revenue is an important number because it helps us understand the size of a company's business. However, generating $100,000 in revenue does not mean the company has made $100,000 in profit. To sell coffee, the company must purchase coffee beans, milk, cups, and other supplies. The direct costs of producing the goods or services sold are called the cost of goods sold, often shortened to COGS. What happens if the company's cost of goods sold is $40,000? Subtracting $40,000 from $100,000 leaves $60,000. This amount is called gross profit. Gross profit shows how much money remains from sales after accounting for the direct costs of the products or services sold. But a company has other expenses besides the cost of goods sold. It may need to pay rent, hire employees, and advertise to attract customers. Expenses related to selling products and managing the business are generally included in operating expenses. Suppose the coffee company spends $30,000 on these operating expenses during the year. Subtracting $30,000 from its gross profit of $60,000 leaves $30,000. This is called operating income, also known as operating profit. Operating income shows how much profit a company generates from its main business operations. Does that mean the company's final profit is $30,000? Not necessarily. If the company borrowed money from a bank, it may have to pay interest. It may also have to pay income taxes. On the other hand, the company might earn interest on its savings or make a profit by selling an asset it owns. For example, suppose the company has $5,000 in interest expense and $5,000 in income tax expense, with no other income or expenses. Subtracting these amounts from its operating income of $30,000 leaves $20,000. This final amount is called net income. Net income represents the company's profit after accounting for its various revenues and expenses during the period. Here is a simplified income statement for our coffee company. Revenue : $100,000 Cost of Goods Sold : $40,000 Gross Profit : $60,000 Operating Expenses : $30,000 Operating Income : $30,000 Interest Expense : $5,000 Income Tax Expense : $5,000 Net Income : $20,000 As this example shows, an income statement explains how a company's revenue turns into profit after different expenses are taken into account. So what should investors look for when reading an income statement? One useful starting point is whether the company's revenue is growing over time. Increasing revenue may mean the company is selling more products or services, charging higher prices, or both. However, rising revenue is not always a sign of improving financial performance. If a company's expenses grow faster than its revenue, its profit may actually decrease. This is why investors should examine not only revenue but also changes in operating income and net income. It is also important to understand how much profit a company earns relative to its revenue. For example, if a company generates $100,000 in revenue and earns $30,000 in operating income, its operating profit margin is 30%. This means the company earns $30 in operating profit for every $100 in revenue. Looking at operating profit margins can help investors understand how efficiently a company turns sales into operating profit. Another important point is the difference between operating income and net income. A company might earn very little profit from its main business but report a large net income because it sold a building for a one-time gain. In that situation, net income may increase significantly, but the same gain might not happen again the following year. There is one more thing to remember. The profit reported on an income statement is not necessarily the same as the amount of cash that actually enters a company's bank account. For example, a company may record revenue after selling a product even if the customer has not paid yet. To understand how cash actually moves into and out of a company, investors also need to examine another financial statement called the cash flow statement. Ultimately, the income statement tells us how much revenue a company generates, what expenses it incurs, and how much profit it earns. Buying a stock is not simply about waiting for its price to rise. It means becoming a part-owner of a business. Understanding the income statement is therefore one of the first steps toward evaluating the financial performance of a company you may want to invest in.