How do I read and analyze an income statement?

The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the revenues, expenses and net income generated by an organization over a specific period of time. It is one of the most heavily scrutinized financial statements issued by every organization. And though the data contained within this document is relatively simple, there is a great deal of useful information that can be garnered from it to help assess a firm's historical financial performance and develop an estimate of its future prospects. Because of this, it is critical for users to have a sound understanding of the story every income statement is trying to tell.

While almost no two income statements look the same, they all possess a common set of data: total revenue, total expenses and net income. Though this represents the minimum amount of data that must be provided, additional details for each section are frequently included to give users more insight into the organization’s financial activities. Some of the most common line items, and the order in which they appear, are listed below.

Product-level revenue: This line item depicts the revenue associated with a specific product the firm sells. There may be multiple lines if the organization sells several different products.

Cost of goods sold (COGS): This expense line item denotes the costs directly tied to the product. For example, a paper mill lists the cost of the pulp used to manufacture paper in the COGS section. (For related reading, see: What qualifies as "goods" in costs of goods sold (COGS)?)

Gross profit: This is the amount of revenue left over after subtracting COGS. Simply put, this is the amount of revenue available to pay for operational expenses and compensate ownership.

Selling, general, and administrative expense (SG&A): This expense line item is an aggregation of all costs related to the sale of the firm’s product(s) and the general operation of the organization.

Interest Expense: This operating expense line item shows how much interest the firm paid to fund its operations during the period.

Income statements are meant to provide users with insights into the financial performance of an organization. There are numerous metrics and analyses that can be developed with this data to provide more in-depth assessments of the organization. However, when used in comparative company analysis, these metrics really become valuable. In this type of analysis, income statement metrics such as total revenue growth and gross profit margin are calculated for similar companies within an industry and compared to one another. For example, see the metrics associated with a pair of technology manufacturers below.

TechOne

Revenue growth: 12.6%

Gross profit margin: 74%

Net profit margin: 35%

Net income growth: 18.6%

Alpha Systems

Revenue growth: 16.2%

Gross profit margin: 67%

Net profit margin: 35%

Net income growth: 19.6%

For an investor looking to purchases shares of a technology manufacturer, comparing the statistics of these two companies yields a number of insights that are not obvious if viewed on a standalone basis. The following are just a few of the conclusions that can be drawn.

1) On both a revenue and net income growth basis, Alpha Systems is outperforming TechOne. As future growth prospects are highly important to every investor, Alpha Systems appears to be the more attractive option.

2) TechOne has a lower COGS due to its higher gross profit margin than Alpha Systems. This suggests that TechOne is able to source its inputs for less than Alpha Systems, which could be indicative of an inherent competitive advantage.

3) Despite both firms having the same net profit margin, Alpha Systems appears to have lower operating costs than TechOne based on the differences between gross and net profit margins. This implies Alpha Systems is operating its business more efficiently than TechOne.

There are numerous other analyses that can be performed as part of any comparative company analysis using the income statement. The point is that any income statement analysis should include some form of comparative analysis to give the reported numbers, and associated metrics, the needed context. By doing so, investors, management and others are able to fully understand how an organization is performing financially and make informed decisions accordingly. (For related reading, see: Find Investment Quality in the Income Statement.)