4.1. Presenting a Typical Income Statement

At the risk of oversimplification, I would say that businesses make profit three basic ways:

• Selling products (with allied services) and controlling the cost of the products sold and other operating costs

• Selling services and controlling the cost of providing the services and other operating costs

• Investing in assets that generate investment income and market value gains and controlling operating costs

Obviously, this list isn't exhaustive, but it captures a large slice of business activity. In this chapter, I concentrate on the first category of activity: selling products. Products range from automobiles to computers to food to clothes to jewelry. The customers of a business may be the final consumers in the economic chain, or a business may sell to other businesses.

Figure 4-1 presents a typical profit report for a product-oriented business; this report, called the income statement, would be sent to its outside owners and lenders. The report could just as easily be called the net income statement because the bottom-line profit term preferred by accountants is net income, but the word net is dropped off the title. Alternative titles for the external profit report include earnings statement, operating statement, statement of operating results, and statement of earnings. (Note that profit reports distributed to managers inside a business are usually called P&L [profit and loss] statements, but this moniker is not used in external financial reporting.)

Figure 4.1. A typical income statement for a business that sells products.

The heading of an income statement identifies the business (which in this example is incorporated — thus the term "Inc." following the name), the financial statement title ("Income Statement"), and the time period summarized by the statement ("Year Ended December 31, 2009"). I explain the legal organization structures of businesses in Chapter 8.

You may be tempted to start reading an income statement at the bottom line. But this financial report is designed for you to read from the top line (sales revenue) and proceed down to the last — the bottom line (net income). Each step down the ladder in an income statement involves the deduction of an expense. In Figure 4-1, four expenses are deducted from the sales revenue amount, and four profit lines are given: gross margin; operating earnings; earnings before income tax; and, finally, net income.

If a business sells services and does not sell products, it does not have a cost of goods sold expense; therefore, the company does not show a gross margin line. On the other hand, some service-based businesses disclose a "cost of sales expense" that is analogous to the cost of goods sold expense reported by product-based companies, in which case a gross margin line is reported. I should caution you that you find many variations on the basic income statement example I show in Figure 4-1. In particular, a business has a fair amount of latitude regarding the number of expense lines to disclose in its external income statement.

4.1.1. Taking care of some housekeeping details

I want to point out a few things about income statements that accountants assume everyone knows but, in fact, are not obvious to many people. (Accountants do this a lot: They assume that the people using financial statements know a good deal about the customs and conventions of financial reporting, so they don't make things as clear as they could.) For an accountant, the following facts are second-nature:

• Minus signs are missing. Expenses are deductions from sales revenue, but hardly ever do you see minus signs in front of expense amounts to indicate that they are deductions. Forget about minus signs in income statements, and in other financial statements as well. Sometimes parentheses are put around a deduction to signal that it's a negative number, but that's the most you can expect to see.

• Your eye is drawn to the bottom line. Putting a double underline under the final (bottom-line) profit number for emphasis is common practice but not universal. Instead, net income may be shown in bold type. You generally don't see anything as garish as a fat arrow pointing to the profit number or a big smiley encircling the profit number — but again, tastes vary.

• Profit isn't usually called profit. As you see in Figure 4-1, bottom-line profit is called net income. Businesses use other terms as well, such as net earnings or just earnings. (Can't accountants agree on anything?) In this book, I use the terms net income and profit interchangeably.

• You don't get details about sales revenue. The sales revenue amount in an income statement is the combined total of all sales during the year; you can't tell how many different sales were made, how many different customers the company sold products to, or how the sales were distributed over the 12 months of the year. (Public companies are required to release quarterly income statements during the year, and they include a special summary of quarter-by-quarter results in their annual financial reports; private businesses may or may not release quarterly sales data.) Sales revenue does not include sales and excise taxes that the business collects from its customers and remits to the government.

  Note: In addition to sales revenue from selling products and/or services, a business may have income from other sources. For instance, a business may have earnings from investments in marketable securities. In its income statement, investment income goes on a separate line and is not commingled with sales revenue. (The business featured in Figure 4-1 does not have investment income.)

• Gross margin matters. The cost of goods sold expense is the cost of products sold to customers, the sales revenue of which is reported on the sales revenue line. The idea is to match up the sales revenue of goods sold with the cost of goods sold and show the gross margin (also called gross profit), which is the profit before other expenses are deducted. The other expenses could in total be more than gross margin, in which case the business would have a loss for the period.

  Note: Companies that sell services rather than products (such as airlines, movie theaters, and CPA firms) do not have a cost of goods sold expense line in their income statements, although as I mention above, some service companies report a cost of sales expense and a corresponding gross margin line.

• Operating costs are lumped together. The broad category selling, general, and administrative expenses (refer to Figure 4-1) consists of a wide variety of costs of operating the business and making sales. Some examples are:

  • Labor costs (wages, salaries, and benefits paid to employees)

  • Insurance premiums

  • Property taxes on buildings and land

  • Cost of gas and electric utilities

  • Travel and entertainment costs

  • Telephone and Internet charges

  • Depreciation of operating assets that are used more than one year (including buildings, land improvements, cars and trucks, computers, office furniture, tools and machinery, and shelving)

  • Advertising and sales promotion expenditures

  • Legal and audit costs

As with sales revenue, you don't get much detail about operating expenses in a typical income statement.

4.1.2. Your job: Asking questions!

The worst thing you can do when presented with an income statement is to be a passive reader. You should be inquisitive. An income statement is not fulfilling its purpose unless you grab it by its numbers and starting asking questions.

For example, you should be curious regarding the size of the business (see the nearby sidebar "How big is a big business, and how small is a small business?"). Another question to ask is: How does profit compare with sales revenue for the year? Profit (net income) equals what's left over from sales revenue after you deduct all expenses. The business featured in Figure 4-1 squeezed $1.69 million profit from its $26 million sales revenue for the year, which equals 6.5 percent. This ratio of profit to sales revenue means expenses absorbed 93.5 percent of sales revenue. Although it may seem rather thin, a 6.5 percent profit margin on sales is quite acceptable for many businesses. (Some businesses consistently make a bottom-line profit of 10 to 20 percent of sales, and others are satisfied with a 1 or 2 percent profit margin on sales revenue.) Profit ratios on sales vary widely from industry to industry.

In the example shown in Figure 4-1, expenses such as labor costs and advertising expenditures are buried in the all-inclusive selling, general, and administrative expenses line. (If the business manufactures the products it sells instead of buying them from another business, a good part of its annual labor cost is included in its cost of goods sold expense line.) Some companies disclose specific expenses such as advertising and marketing costs, research and development costs, and other significant expenses. In short, income statement expense disclosure practices vary considerably from business to business.

Another set of questions you should ask in reading an income statement concern the profit performance of the business. Refer again to the company's profit performance report (refer to Figure 4-1). Profit-wise, how did the business do? Underneath this question is the implicit question: relative to what? Generally speaking, three sorts of benchmarks are used for evaluating profit performance:

• Comparisons with broad, industry-wide performance averages

• Comparisons with immediate competitors' performances

• Comparisons with the business's performance in recent years

Chapter 13 explains the analysis of profit performance and key ratios that are computed for this purpose.