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Understanding income statements

Useful tips on how to use company reports to pick out a business’s strengths and weaknesses.

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 have three key components – the income statement, balance sheet and cash flow statement.

Over the next three weeks we’ll be taking a look at each in turn, taking you through each and giving you some useful tips on how to use company reports to pick out a business’s strengths and weaknesses.

What is an income statement?

In its simplest form 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.

2019
(£ '000)
2018
(£ '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 profits (/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

Breaking down profit

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 profits measures that are higher up the income statement, but always remember that ultimately it’s profit after tax that goes to shareholders – nothing else.

Working from the top down, the first profit number you come across is ‘gross profit’. This 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 2019.

But the costs of buying or manufacturing product isn’t the only cost 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.

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.

Other costs – depreciation

You’ll notice in our example that we’ve included Research & Development (R&D) and Selling, General & Administration Expense (SG&A) spending in operating expenses. But there’s also an ‘other’ category. Other expenses can include a whole range of things, and 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 that’s been incurred during the year. Think how a car loses value as it puts 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 the equipment will need to be replaced.

Getting to the bottom line

Looking further down the income statement, management also has some control over the finance costs, which are taken away 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. But most companies will only be able to shift their interest expenses 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. So it usually takes a back seat when it comes to analysis.

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 per share.

It’s useful for a few reasons.

Firstly it can be used to work out 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) and tells you how many times the company would be able to pay the dividend out of this year’s earnings.

A dividend cover of less than one is a major warning sign about the dividend, and most of the time we’d be more comfortable with a dividend coverage ratio of more like 2 times.

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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This article, like our insight emails, isn’t personal advice. You shouldn’t make an investment decision based on income statements alone. If you’re not sure an investment is right for you, you should ask for financial advice.

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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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