How to Read and Analyze an Income

Statement
 5 Min. Read  Managing  By: Heather Liston

Ever feel a little left out when people start chatting about P&L’s?  How about when the talk turns to
income statements, or profit and loss reports, or even a “statement of activities”? The first bit of good
news is that all of these refer to the same thing, so you may not have as much to learn as you
thought. The second is that an income statement is based on a  few very simple concepts, which
you already understand.
The basic suite of financial statements a company produces, at least annually, consists of the
statement of cash flows, the balance sheet (or statement of financial position), and the income
statement.

The ones that people most often look at (and most often pretend to understand), are the latter two.
The major difference between them is this: the balance sheet is essentially a snapshot, while the
income statement is a movie. In other words, the balance sheet shows what you own (assets) and
what you owe (liabilities) at a moment in time (most often as of December 31). The income
statement shows what happens over a period of time (usually a year): what comes in, what goes out,
and what’s left over at the end.

Here is an example of a basic income statement, covering the period of one month:

Revenue (or Gross Income):


o

 Allowance          $2.00

Expenses:


o

 Candy               ($1.50)

Net Income:                  $ .50

See how that works? The top section lists money coming in during the period, the middle section
lists money going out, and the bottom line is the difference between the two. All the math you need
to produce or proofread this statement is a little basic subtraction.

Now flip open the annual report of any Fortune 500 company and find the income statement. What
you see, in basic concept and structure, will be exactly like the one above. The only difference is that
it has a lot more lines.
The annual (financial year ending Sept. 30) income statement for Apple Computers.

As companies get larger, they start making a few common variations on the structure. Many, for
example, have a section at the top that starts with total revenue, then subtracts “cost of revenue”
and shows the difference as “gross profit”.  The “cost of revenue” line is the total of all expenses the
company deems to be directly related to generating the revenue, such as the cost of purchasing
inventory. From the gross profit, they then subtract normal operating expenses, like administration
and research and development, which leads to another sub-total called, usually, “operating income,”
or, more jargonistically, EBIT or EBITDA (Earnings before Interest, Taxes, Depreciation, and
Amortization). From that, obviously, interest and taxes (and maybe depreciation and amortization)
have to be subtracted before the statement shows the final net income line.

All the complexity sketched out in the previous paragraph, though, is nothing more than a little
rearrangement of the basic elements—income and expenses—into some sub-categories. The same
principles still apply, even when things start to look complicated. No matter what, the income
statement includes just income, expenses, and differences between the two. And income is always
listed before expense in any group; it’s just that some companies do more sub-grouping before they
get to the bottom line.

No matter what twists and turns you take along the way, the last number on the income statement is
crucial. It is labeled “Net Income” above, but it also goes by names like “surplus,” “the bottom line,”
or maybe “contribution to savings.” If the bottom line is a negative number, it will most often be called
the “deficit” or “loss.” The math and the meaning are exactly the same; these are purely terminology
issues.

If you’re asked to review an income statement and you’re not sure where to start, here are a few
things to do:

1. Check all the math.

Yes, errors occur even in printed, published statements; even in ones produced by major
companies. If you find an error, you look smart—and you might also uncover something that
changes the results completely. Also, as you run through the adding and subtracting, you will
improve your own understanding of exactly how the numbers fit together.

2. Find the bottom line. (Should be easy—it’s at the bottom.)

On a very basic level, it’s good to see a positive number there. That means the company earned
more than it spent during this period. That means it can pay its employees, keep the lights on, and
not be forced to borrow money.  But if that bottom line is preceded by a minus sign, or printed in red,
or enclosed in parentheses, then expenses exceeded revenue. Find out why. And what the plan is
for making the red turn to black.

A net loss once in a while does not necessarily imply disaster. Sometimes new companies have a lot
of start-up costs and do not expect to turn a profit in the first year or three. Or maybe the business in
question is a cyclical one, like agriculture: if your company grows corn and there was no rain this
year you will likely show a loss.  Perfectly normal; some years are up; some are down. On the other
hand, if net losses become a trend, or if the company does not have enough cash to fund its
expenses during the down times, there could be a problem.

3. Look at the sources of income.

Do they make sense for the business? For example, if you’re in the cotton candy business, then
sales income from the county fair sounds right. But if one income line is “gifts from friends” that’s
probably not sustainable. What about next year when those friends don’t come through again?

Or say you’re reviewing the statements for a museum. Ten percent of their income came from
admission fees last year and 90 percent came from ticket sales for a special blockbuster exhibit that
came through town. Fine, as long as there will be a new blockbuster exhibit every year. If that was a
non-repeatable event, though, you will want to ask questions about whether the revenue model is
sustainable.

4. Look at the expense categories.

Are they logical? For most businesses, you will see salaries and wages, insurance, rent, supplies,
interest, and at least a few other things. Is anything missing that you would expect to see?  For
example, if the business has a hundred employees and you don’t see rent, or mortgage interest, find
out why. Is there an office? If not, why not? If yes, how is it being paid for?

5. Now look at the amounts: What are the biggest expenses?

If this is a service business, expect to see a large number for salaries. If it’s a manufacturing
business, materials and supplies may logically be a significant total. On the other hand, what if you
know the company has only three employees but the salary line is extremely high? Is someone
being overpaid? Are there more people working there than you realized? Or what if the president
told you the company has been profitable for years but you see high interest expense? Find out why
the company is borrowing money, and from whom, and whether they’re paying a reasonable rate.

6. Compare year-over-year numbers.

Usually, the income statement will have separate column showing the figures for the prior year. If the
document doesn’t already show the percentage change in every category, calculate those numbers
yourself. Question any significant changes. Like, why is sales income 50 percent lower this year than
last? Why is insurance 20 percent lower? Did the entity rack up such a great safety record that the
insurer lowered its rates? Maybe. But maybe the reduced insurance number has a negative cause—
like one of the policies was canceled and the company is at risk in some way.

7. Think about logical relationships between numbers.

For example, at most companies these days employee benefits (like health insurance, retirement
plan contributions, parking passes) are a significant cost. If the salary line doubled but the benefits
number went up by only 10 percent, that should strike you as odd. Is there some reason the new
employees do not qualify for benefits? Did the company drop one of its benefit plans?

All these questions may have perfectly reasonable answers, but sorting through them will help you
understand what’s going on, and give you confidence that you know what you’re talking about when
it comes to income statements.