Overview of the Income Statement; As an in-house lawyer, you should have a fundamental understanding of how to interpret your company’s financial statements. Legal issues frequently intersect with financial issues for the company and you will routinely have to interact with accountants and auditors. You should therefore be well-versed in how to read the three main types of financial statements—the income statement, the balance sheet, and the statement of cash flows.
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A basic income statement typically contains the following line items:
Less: Cost of Goods Sold (COGS)
= Gross Profit
Less: Selling, General and Administrative (SG&A)
= Operating Income (EBIT)
Less: Net Interest Expense
= Earnings Before Tax
Less: Income Tax Expense
= Net Income
The top line item on an income statement is revenue. The revenue number represents the value received from customers as a result of the company’s products and/or services.
Sometimes, an income statement presents line items for gross and net revenue. The net revenue is calculated by taking the gross revenue and subtracting for any adjustments. Such adjustments may include reducing revenue for sales discounts, returns, delayed payments, or expected uncollectible amounts.
Cost of Goods Sold
The cost of goods sold, or COGS, represents the direct costs that can be easily matched to revenue. Some examples of COGS include the cost of raw materials and the cost of labor used to produce the goods being sold.
Gross profit represents the difference between revenue and its COGS.
Gross profit is an important metric for providing insight into the profitability of a company’s basic operations. If the gross profit value on a company’s income statement is small, this could be an indication of low sales volume, low sales prices, or high direct costs.
However, it is important to interpret this information in the context of the overall industry the company operates it. For example, software companies tend to have higher gross profit numbers by virtue of the fact that they have limited production and delivery costs. In contrast, retail companies generally have lower gross profit numbers.
Selling, General and Administrative (SG&A) Expenses
Costs that cannot be directly matched to revenue are part of an income statement line item called selling, general and administrative (SG&A). The SG&A line item typically consists of indirect expenses such as marketing and advertising, professional services, research and development (R&D), and office expenses.
Some companies opt to include certain indirect costs as separate line items on their income statements. For example, a retail company may include marketing expense as a separate line item because it represents a particularly significant expense for the company.
Operating Income (EBIT)
Operating income is a measure of a company’s profit from normal operations. It is often referred to as EBIT, or earnings before income and taxes.
EBIT is one of the most commonly used metrics by investment bankers for relative valuation and peer comparisons. A strong EBIT margin is a sign of a profitable business.
Operating Income = Gross Margin – SG&A
Operating Margin = Operating Income / Revenue
Depreciation and Amortization Expense
Under the accrual accounting method, certain long-term assets are depreciated over a number of years on the company’s financial statements. In other words, when a company purchases a tangible, long-term asset such as a building or equipment, a portion of the cost of the asset is treated as an expense each period over the useful life of the tangible asset. Amortization involves the application of a similar concept to intangible assets.
There are different ways to calculate asset depreciation, including the straight-lined and accelerated depreciation methods. Accounting rules dictate how different categories of assets are depreciated.
While not typically a line item on the income statement, EBITDA is a key proxy of a company’s operating cash flow. EBITDA stands for earnings before interest, taxes, depreciation and amortization.
EBITDA is calculated by taking EBIT (or operating income) and adding depreciation and amortization expense. It provides a good estimate of a company’s operating cash flow because it takes operating income and subtracts what is typically the largest non-cash expense for the company.
EBITDA = EBIT + D&A
Companies typically just present one line item for net interest expense on their income statement. Interest expense encompasses the aggregated interest that a company owes its lenders or noteholders. Interest income encompasses the interest that a company earns from its interest-earning cash balances.
Interest expense is considered a non-operating line item. This is because it is affected by a company’s capital structure, rather than just being impacted by a company’s operations.
Net Interest Expense = Interest Expense – Interest Income
The tax expense line item reflects the income taxes that a company must pay to various tax authorities. A company’s tax expense in a given period may be lowered by the availability of NOLs, or net operating loss carryforwards. NOLs can help a company offset future taxes.
Net income is derived by taking the earnings before tax value and subtracting tax expenses.
Net Income = Earnings Before Tax – Tax Expense
Net Income Margin = Net Income / Revenue
While high net income is generally an indicator of a profitable business, net income is often significantly impacted by non-operating expenses. Therefore, companies often present an adjusted net income value to investors.
Earnings per Share
Below the net income line item, companies generally will provide earnings per share, or EPS.
Earnings Per Share (EPS) = Net Income / Number of Common Shares
Companies typically present two distinct EPS numbers—the basic EPS and the fully diluted EPS. The distinction involves using a slightly different value in the denominator of the EPS calculation. The basic share count represents the company’s total number of common shares currently outstanding. The fully diluted share count represents the basic shares plus the additional shares that could be available from the conversion of stock options, warrants, and other convertible securities.