An income statement also called a Profit and loss account (P&L) is a financial statement that shows the company’s revenues from sales, expenditures, and profits over a specific time. In simple words, it explains how the company's net revenue is converted into net earnings whether profits or losses giving insights into the financial health of a business, and it is a keystone for strategic planning, budgeting, financial forecast, and investment decision-making. It is prepared on a monthly, quarterly, semi-annually, and/ or annual basis.
How to read an income statement?
The revenues part shows the company’s earnings from selling its products and services only. The cost of goods sold (COGS) part denotes the direct costs of production, then gross profit is calculated by subtracting COGC from revenues to show the amount of revenue available to cover operational expenses and compensate shareholders. Selling, general, and administrative (SG&A) shows all other indirect expenses related to the general operations of the business including rent, marketing, office supplies, etc. Operating income is the remaining amount after subtracting the SG&A expenses from the gross profit. Interest Expense shows the costs of the firm’s borrowings. The Non-operating income shows the gains and losses from non-core activities such as an increase in the value of an asset, or income from selling an asset, or a loss such as the cost of settlement of a consumer lawsuit. The Earnings before taxes (EBT) or also called income before taxes (IBT), is the remaining cash after deducting all costs and losses from all gains and revenues. Since businesses pay taxes at various rates based on their region, EBT is frequently used as a profitability measure. And finally, the Net income or also called Net Profit is the remaining amount for the shareholders after deducting taxes, interest, depreciation, and amortization. Statement of income could also include Basic and/or Diluted Net income per share which indicates how much the company’s income was allocated to each share of common stock, and the difference between both the basic and diluted is that diluted EPS takes into account all convertible securities[ An investment that can be transformed from its original form into another is referred to as a convertible security. Convertible bonds and preferred shares that can be converted into common stock are the two most well-known forms of convertible securities. A convertible security defines the requirements and conversion price and pays a certain amount on a regular basis (a coupon payment for convertible bonds and a preferred dividend for convertible preferred shares).] while basic EPS takes into account only a company’s common share. The Diluted EPS encompasses a broader view of potential per-share profitability.
|Basic EPS =
|Net Income - Preferred Dividends
|Weighted Average of Outstanding Shares
|Diluted EPS =
|Net Income + Convertible Preferred Dividends + Debt Interest
|Weighted Average of Outstanding Shares + Convertible Securities
A rise in basic EPS can cause a stock's price to increase in tandem with the company's rising earnings per share because stocks trade on multiples of earnings per share. However, an increase in basic EPS does not necessarily translate into an increase in the company's gross earnings. Businesses have the option to repurchase shares, which lowers their overall share count and allows them to distribute net income less preferred dividends over fewer common shares. Even if absolute earnings decline due to a decline in the number of common shares outstanding, basic EPS may rise. The difference between basic and diluted EPS is another factor to take into account. The likelihood of future dilution of current common shareholders may be considered if the two EPS measurements diverge more and more over time.
How do we analyze an income statement?
There are two ways to analyze a financial statement: vertical and horizontal analysis. Vertical analysis is comparing each item to revenues as a percentage, while horizontal analysis is calculating the percentage change of each item on a year-over-year basis.
An investment that can be transformed from its original form into another is referred to as a convertible security. Convertible bonds and preferred shares that can be converted into common stock are the two most well-known forms of convertible securities. A convertible security defines the requirements and conversion price and pays a certain amount on a regular basis (a coupon payment for convertible bonds and a preferred dividend for convertible preferred shares).
For example, looking at Coca-Cola Co.’s (KO) income statement for the Quarter that ended on June 1st, 2022, we could see that the Cost of goods sold (COGS) in Q2 2022 is $4.83 bn compared to $3.787 bn in Q2 2021. If we are conducting a vertical analysis we would show that COGS in Q2 2022 is 42.64 % of the total revenues, while it was 37.3% of the revenues in Q2 2021. However, if we were horizontally analyzing the statement, we would show that COGS increased by 12% y-o-y in Q2 2022 compared to Q2 2021, as seen below.
An investor can understand what makes a company profitable by knowing the income and expense components of the statement. If a company saw a significant gain in revenue during the period under consideration while simultaneously managing its spending side of the business. This is a sign of effective management. Understanding fundamental analysis assists in choose between potential investments.
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