The income statement is one of the most important financial statements produced by a company. In a nutshell, the income statement is a summary of operations for a given period (year or quarter) which outlines revenue, cost, and profit produced by the firm. When a company “announces earnings” this is invariably the document which is being referenced. It is also where the Net Income and Earnings Per Share (EPS) metrics are found. However, keep in mind that earnings numbers can be manipulated using fancy or “creative” accounting techniques which can hide unfavorable performance. Therefore, it is always important to maintain a critical eye when reviewing this document - and to cross reference the Statement of Cash Flows as well. The major components of the Income Statement are outlined below.
Revenue
In general, revenue is any sale which is “booked” in a given time period. For example, when you buy a book or magazine from Barnes & Noble, that sale is booked as revenue for the time period in which you bought it. In this case, the store actually receives the amount owed at the time of sale. However, in other cases, such as when a company buys a large number of computers from a company like Dell - the revenue is booked at the time of sale, even though the purchasing company may not pay the entire amount until later.
Cost of Goods Sold (COGS)
COGS outlines any direct cost of producing / manufacturing the products sold by a company. For example, the cost of any parts used to build a Dell computer would be included in COGS.
Gross Profit & Gross Profit Margin
If you subtract COGS from revenue, you get what is called “gross profit”. That is, the amount of money remaining after the direct costs of producing the product are subtracted. You will often also see this expressed as a percentage of revenue (called the gross profit margin). The formula is:
Operating Profit & Operating Margin
However, if we go one level deeper and subtract the indirect costs to the business such as Sales, General, and Administrative expense (SG&A) as well as adjust for depreciation & amortization we arrive at Operating Profit. Also known as Earnings Before Interest and Taxes (EBIT), operating profit is a good measure of business performance because it captures profit derived purely from the operations of the business (i.e., it is not impacted by tax structure or the cost of borrowing money). The Operating Margin is calculated in the same way as the gross profit margin:
Net Income
Finally, when taxes and interest expense are subtracted from operating profit we arrive at Net Income or Net “Earnings”. This number, which represents the total profit of the firm, is then used to calculate the Earnings Per Share (EPS) ratio:
Further, the Net Margin is given by:
