Understanding the Income Statement
Originally Published: April 2010
Components of the Income Statement: What They Tell UsSales or Revenues (“Net Sales” on the sample): Often called the “top line”, it represents the amount the company sold during the period.
Note #1: Looking at LLH’s Income Statement, you can see that the corporation’s Net Sales have increased more than 34% since 2007.
Cost of Goods Sold (“Cost of Sales” on the sample): The amount it costs to make or procure the products or services an organization sells. For manufacturing firms this includes the direct cost of raw materials, labor, and manufacturing overhead to make the product. For wholesalers and retailers, it is the purchase cost of the merchandise sold. For service companies, it's the direct costs involved in providing the service.
Note #2: While LLH’s Net Sales increased 34% in 2009 over 2007, their Cost of Sales grew just 29%. Thus, Sales outstripped Costs over that 3-year period.
Gross Margin (“Gross Profit” on the sample; also could be "Gross Loss"): This represents Net Sales minus Cost of Goods Sold. It’s important to look at this number over time, as a trend. If there is an increase in sales, with a drop in the gross margin to sales ratio, it's an indication the company is growing weak on the top line and may be in jeopardy.
Note #3: As can be seen on LLH’s Income Statement there has been a very healthy increase in Gross Margin of 44% between 2007 and 2009. Therefore, in this case the “top line” (Net Sales) appears to be strong.
Selling, General and Administrative Expenses (SG&A): Often called “overhead” or “fixed costs”, these represent the organization’s operational expenses not directly related to making or procuring their products/services. For instance: salaries, commissions, marketing costs, utilities, insurance, office supplies, etc. The goal is to keep these expenses as low as possible. The trend of these expenses as a percentage of sales should be watched closely to detect signs of managerial inefficiency.
Note #4: In LLH’s case, the trend of these general expenses as a percentage of sales is generally holding steady
- 2007: General Expenses = 29% of Net Sales
- 2008: General Expenses = 27% of Net Sales
- 2009: General Expenses = 28% of Net Sales
Operating Income: Gross Profits minus SG&A. The company’s earnings from its normal operations, before interest, non-operating income and costs, taxes, etc. Operating income is viewed by some analysts as more reliable than net income as a measure of profitability.
Note #5: LLH’s Operating Income grew 132% from 2007 to 2009.
Interest Expense: The costs of the company’s credit lines and other borrowings.
Note #6: Interest expense showed a significant decrease from 2007 ($722,000) to 2009 (2,000).
Other (Income) Expense: Items not related to the primary business activities of the company, for instance income from subletting space, patents, unusual or infrequent gains and losses.
Income Before Income Taxes or Pretax Income: This is exactly what the name describes. As there are many ways to avoid or decrease income tax expense, some analysts consider this pretax income as an accurate measure of the company’s profitability.
Note #7: Income Before Taxes has shown increases:
- 2007 to 2008: 104%
- 2008 to 2009: 17%
Provision for Income Taxes: What the organization expects to have to pay in income taxes for the period.
Net Income: Called the “bottom line” – because it actually is the last line of the statement. This is the profit (or loss) for the period covered by the Income Statement. Obviously, you want to see a positive number here; the higher, the better.
Note #8: LLH’s Net Income increased 96% 2007 to 2008 and 22% 2008 to 2009. Overall, there was a 138% increase in Net Income from 2007 to 2009.
Earnings per Share (EPS) (Net Income per Common Share – “Basic: and “Diluted” on the sample): Earnings per share are required to be disclosed on the Income Statement. “Basic” is a weighted average of shares outstanding and includes only stocks outstanding. “Diluted” is also a weighted average, but is calculated as if all stock options, warrants, convertible bonds and other securities that could be transformed into shares have been. Diluted earnings per share is considered the most reliable way to measure EPS.
Conclusions from Reviewing Data in the Income StatementOverall, LLH Inc. has shown a tremendous improvement from 2007 through 2009 in all areas:
- Net Sales up 34%
- Gross Margin up 44%
- Operating Income up 132%
- Interest Expenses down more than 99%
- Net Income up 138%
While a credit decision should never be made looking at one financial statement alone, the numbers in LLH’s Income Statement certainly show a very positive trend.
Some Limitations of the Income StatementBefore going further, it should be noted that there are some limitations to the information found on the Income Statement:
- Only items that can be measured with accuracy are included. Some items not included are: unrealized gains or losses on investments or increases in a company’s value due to branding, quality and loyalty.
- Some numbers depend on the accounting method utilized (e.g. FIFO or LIFO to measure inventory levels).
- Depreciation methods, accelerated or straight line, can have a major impact on net income.
- Subjective judgments, in particular as related to “useful life” and “salvage value”, can significantly increase (or decrease) net income.
Using the Income Statement to Determine the Financial Health of a Business
There are many ratios, and formulas for those ratios, used in financial analysis. We cover just a few of them below.
Income Statement Ratios
These ratios utilize figures from the Income Statement alone. We've provided the ratios for each of years 2009, 2008 and 2007 in order to show the trends in LLH’s business performance.
Gross Margin Ratio = Gross Profit ÷ Net Sales
This measures the percentage of sales dollars available to pay the overhead expenses of the company.
A related ratio is the Net Profit Margin Ratio: Net Income Before Income Taxes ÷ Net Sales.
Both ratios determine the percentage of profits for each sales dollar obtained. The higher the ratio, the higher the profit margin.
|Gross Margin||194,677 ÷ 544,568
|167,678 ÷ 482,179
|135,114 ÷ 405,307
|Net Profit Margin||44,105 ÷ 544,568
|37,792 ÷ 482,179
|18,497 ÷ 405,307
Other Ratios Utilizing Both the Income Statement and Balance Sheet Information
“Net Sales” is for the entire period (in this case the year) and “Inventory” represents the inventory balance at the end of the year. The Inventory Turnover ratio measures the efficiency of inventory management. The more times inventory is turned in an operating cycle, the greater the profit.
|Inventory Turnover||544,568 ÷ 133,342
|482,179 ÷ 88,731
While showing good profitability trends, LHH had a decrease in inventory turnover from 2008 to 2009. What might this suggest?
Return on Equity = Net Profit after Taxes (Net Income on Income Statement) ÷ Net Worth (Total Stockholders’ Equity on Balance Sheet)
This ratio measures the ability of the company to realize an adequate return on capital invested by the owners. The higher the number, the more efficiently management is utilizing this capital. Again, LLH shows a decreasing trend.
|Return on Equity||26.924 ÷ 148,434
|22,149 ÷ 114,397
Return on Assets = Net Profit after Taxes (Net Income on Income Statement) ÷ Total Assets (Balance Sheet)
This ratio indicates how efficiently management is using its assets to generate earnings. An increase in this percentage is a positive sign. You’ll note there was a slight decrease in LLH’s Return on Equity ratio, 2009 compared to 2008.
|Return on Assets||26,924 ÷ 205,880
|22,149 ÷ 152,405
Assets to Sales = Total Assets (Balance Sheet) ÷ Net Sales (Income Statement)
This ratio measures the percentage of investment in assets that is required to generate the current annual sales level. A high percentage may indicate that a business is not aggressive in it sales efforts or is not fully utilizing its assets.
|Inventory Turnover||544,568 ÷ 133,342
482,179 ÷ 88,731
Accounts Payable to Sales = Accounts Payable (Balance Sheet) ÷ Net Sales (Income Statement)
This ratio measures how the company pays its suppliers in relation to the sales volume being transacted. A low percentage indicates a healthy ratio. A high percentage may indicate the business is using suppliers to help finance operations.
|A/P to Sales||32,608 ÷ 554,568
15,373 ÷ 482,179
(See also Understanding the Balance Sheet).