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Understanding financial statements – income statements

With first quarter results in full swing, we revisit our three part series on how to understand financial statements starting with income statements.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Financial statements come in three parts – the income statement, balance sheet and cash flow statement.

Over the next three weeks we're going to be looking at each in detail. We'll be taking investors through each statement and hopefully providing some useful tips on how to use company reports to identify a business's strengths and weaknesses.

This article isn't personal advice and it should be remembered statements and ratios shouldn't be looked at in isolation. Investments and any income they produce can fall as well as rise in value, so you could get back less than you invest. If you're not sure if an investment is right for you then seek advice.

What is an income statement?

An income statement starts with revenues and gradually subtracts costs until you arrive at profits. For this reason revenue is sometimes referred to as the 'top line' while profits are called the 'bottom line'.

We've pulled together a simple example income statement below.

Example income statement

Scroll across to see the full table.

(£ '000)
(£ '000)
Revenue 5,000 4,024
Cost of goods sold 2,000 1,620
Gross profit 3,000 2,404
Operating expenses
Research and Development 310 300
Selling, General and Administrative 250 205
Other (1) 50 35
Total operating expenses 610 540
Operating profit (/loss) 2,390 1,864
Finance income 10 10
Finance expense 120 110
Profit before tax 2,280 1,764
Tax 570 441
Profit after tax 1,710 1,323
Earnings per share (£) 1.43 1.10
Dividend per share (£) 0.71 0.55

False profits

One of the things you might notice about the income statement above is the various types of 'profit'.

Company management teams will often be selective about the type of profit they focus on in reports. There are good reasons for some companies to focus on profit measures that are higher up the income statement. But always remember that ultimately, it's profits after tax that accrue to shareholders – nothing else.

Working from the top down, the first profit number you come across is 'gross profit'. This essentially measures the difference between what a company pays for the goods it sells, and what it charges. It's what you might think of as the 'mark-up' a retailer puts on its stock. The company in the example above achieved a 60% gross margin in 2020.

But the costs of buying or manufacturing product aren't the only costs a company faces. There are also the costs of actually running the business day-to-day. These are called operating expenses and include things like product development spending, head office costs and wages. Remove all these from gross profits and you get operating profit.

You'll notice in our example we've included research and development (R&D) and selling, general and administrative expenses (SG&A), in operating expenses. But there's also an 'other' category. Other expenses can include a whole range of things. To find out exactly what's included you'll have to look in the notes to the accounts – in this case note 1 (as indicated by the annotation next to the word 'Other').

One number you're likely to see included in other operating expenses is depreciation. This represents the wear and tear on company equipment during the year. Think how a car loses value as it accrues more miles on the clock.

Wear and tear might not cost any cash upfront but it's important it's recognised in the overall expenses. Over time equipment will lose value, and at some point it'll need to be replaced.

We tend to focus quite a lot on operating profits, because they're the numbers that managers control and change quarter-to-quarter. Sales can be boosted by marketing or pricing, and costs rise or fall as management see fit to a large degree.

We also pay close attention to operating margins (the percentage of revenues that make it through to operating profit – 47.8% for 2020 in the example above). We think they give an important measure of a company's competitive position, since they show that customers are prepared to pay a premium for the service on offer. They also provide a margin of safety if business takes a turn for the worse.

Looking further down the income statement, management also has some control over the finance costs, which are subtracted to get you to 'profit before tax'. Interest costs make up most of this category, both interest payable on loans the company has taken out and interest received on cash the company holds in the bank.

The more debt a company has, the higher the interest expense. However, most companies will only be able to shift their debt levels slowly. That makes it a less useful measure of quarter-to-quarter performance.

The bottom line of the income statement is 'profit after tax', sometimes called net income or profit attributable to equity holders. In some ways it's the most important number on the income statement – since it represents the final profit the company actually made in the period.

However, with tax rates set by governments, it's not a number that management has direct control of. For that reason it often takes a back seat when we're analysing companies.

Per share numbers

The income statement will often include an earnings per share (EPS) number. This divides profit after tax by the number of shares in issue, giving you an idea of the profit attributable to each share.

It's a useful number for several reasons.

Firstly, it can be used to calculate a price to earnings ratio for the stock. Dividing the share price by the EPS creates a standardised measure of valuation that can be compared across companies of different sizes.

Secondly, it can be used to work out dividend cover. This is calculated by dividing EPS by dividend per share (DPS). It tells you how many times the company would be able to pay the dividend out of this year's earnings.

A number less than one is a major warning sign about the dividend. Most of the time we would be more comfortable with a dividend coverage ratio of around 2 times.

A note on alternative or underlying numbers

One thing we haven't included in this summary is detail on what are called 'adjusted' or 'underlying' numbers.

These numbers are intended to give a better understanding of what's actually happening in a business. That's because they strip out 'one-off' events that impact a company's results but aren't an ongoing effect.

Underlying numbers can be a useful tool for investors in a year where a company has faced a significant fine or perhaps made a major acquisition. They help you see what's going on in the core business.

However, they're also compiled based on management discretion. If a company faces fines of one kind or another every year, is that really an 'exceptional' cost? Lots of companies would argue it is, but we're not so sure.

For that reason, adjusted or underlying numbers aren't allowed in an income statement. If it's a cost, even an exceptional, one off cost, it needs to be reflected in the income statement.

Next week

Next week we'll be looking at balance sheets and particularly what they can tell you about a company's financial strength.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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