How to Analyze an Income Statement 🔍
How to Analyze an Income Statement 🔍
Learn how to read & analyze an income statement in 5 minutes 🧠
Accounting is the language of business
If you invest in individual businesses, you have to learn how to read & analyze an income statement.
Here is a breakdown of how to read & analyze an income statement:
The income statement shows the business' revenues and expenses for a specific time period. By analyzing the income statement, you will understand how fast the business is growing, and whether or not that growth is profitable.
Revenues or Net sales
Revenue is what a business receives from selling its products and services. In our example, the business has made $200,000 in revenues for the year 2020.
Costs of Goods Sold (COGS)
All costs a business makes to produce the products and services they offer. For our example, the business has COGS of $110,000
Gross Profit
What is left after you subtract the COGS from the revenue: If you buy stuff for $110k (COGS), apply your value to the stuff, and sell that stuff for $200k (Revenue), you are left with $90k in Gross profits.
If we want to calculate the Gross Margin, we use the following formula:
Gross profit margin = Revenue - COGS / Revenue x 100
Operating expenses (OpEx)
OpEx is the expenses a business uses to run its day-to-day operations; it consists of 4 main categories: I) Sales & Marketing, II) Research & Development, III) Depreciation & Amortization, and IV) General & Administrative Expenses.
In our example, the business has total operating expenses of $48.2k. We should ask ourselves 2 questions about the operating expenses:
Is the business using excessive amounts of S&M? (Bad sign) For example, some businesses use more S&M than their operating cash flow. This is not sustainable.
Are the R&D investments paying off in any material way? This will show up as new product developments & products/services that create new or expand existing revenue streams (Good sign). Not good if the business is using billions on R&D while not producing material results.
Operating Income (EBIT)
Operating income is also called "EBIT" or "Earnings Before Interest & Taxes". EBIT tells us how much the business is making from its day-to-day operations. We can easily calculate the operating income with the following formula:
Revenue - COGS - Operating expenses = Operating Income
In our example, the operating income, or EBIT is $200k - $110k - $48.2k = $41.8k. From this, we can easily calculate the “Operating Margin” by using the following formula:
EBIT / Revenue x 100 = $41.8k / $200k x 100 = 20.9%
Non-Operating Income & Expenses
Items that are not related to the day-to-day operations of the business. In this post, there can both be positive contributors to net income, or contractors. There are 4 categories: I) Other income (positive), II) Foreign currency (Positive or negative), III) Interest expenses (negative), and IV) Financial instruments (Positive or negative).
Income before income taxes (EBT)
All other expenses are now considered, the only missing element is taxes. The formula:
Income before income taxes = Operating Income - Non-operating income & expenses.
In our example: $41.8k + $3.5k (Interest revenues of 2k + Gains from Investment sales of 1.5k) - $0.6k (Interest expense of (0.6k)) = $44.7k (EBT = $44.7k)
Income Tax Expenses
Taxes the business must pay to the right entity. In our example, they pay an income tax of $0.2k. The taxes are included in “Non-operating and other”, but taxes are usually separate in their own post on the income statement. We can calculate the tax rate with the following formula:
Tax rate = Income Tax Expenses / EBT x 100 Ex: 0.2k / 44.7k x 100 = 4.47%
Net income
Net income is revenue minus all expenses and taxes. This is what investors usually refer to as the profit of the business. Formula:
Net income = Revenue - COGS - Operating Expenses - Other expenses – Taxes
In our example: 200k – 110k – 48.2k + 3.5k – 0.8k = 44.5k
The most important metrics to consider from the Income Statement:
Gross Margin: We want to identify businesses with an above-industry average gross margin that is sustained over time. It is a bonus if the gross margin is expanding, as it indicates pricing power & competitive advantage.
Formula: Revenue - COGS / Revenue x 100
Operating Margin: Same principle as for gross margin. But for operating margin, we also want to pay attention to the development in operating expenses over time. The increase in OpEx can be temporary, which in turn will provide the business with a better operating margin in the future.
Formula: EBIT / Revenue x 100
Earnings per share: The EPS is calculated from the net income less dividends on preferred stock, and divided by the average outstanding shares. EPS is important to track as it indicates the intrinsic value creation per share in the business. A business can grow its net income while issuing new shares. This can result in a business growing its net income by 20%, while not growing its EPS at all. The per-share value then is the same as before.
Formula: Net Income - Dividends on Preferred Stock / Average Shares Outstanding
Learn how to analyze a balance sheet here:
Learn how to identify a compounder here:
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