Reading an income statement

If the balance sheet is a photograph, the income statement is a film. It covers a period, usually a quarter or a year, and shows how the money a company earned from its customers turned into profit, or failed to. Of the three main financial statements, it is the one most often quoted in the news, because it contains the headline numbers: revenue, profit, earnings per share. It is also the one most open to interpretation, which is why it pays to know how it is built.

Merchants have always wanted to know whether their trade was making money, but the modern income statement is a fairly recent invention. For centuries, a merchant’s profit was worked out in the ledger itself, by closing the accounts for each voyage, venture or partnership and seeing what was left. The great merchant houses of Renaissance Europe kept elaborate books. A well-known drawing from around 1517 shows Jakob Fugger of Augsburg, then one of the richest men in Europe, in his counting office with his chief accountant, Matthäus Schwarz, surrounded by a cabinet of drawers labelled with the cities where the firm did business. Regular statements of profit for a fixed period, published for outside investors and drawn up to common rules, only became standard much later, with the rise of joint-stock companies and stock exchanges in the nineteenth and twentieth centuries.

An income statement reads like a staircase, from the top down, with each step subtracting a different kind of cost. It starts with revenue, sometimes called sales or turnover: everything the company billed its customers during the period. Next comes the cost of goods sold, the direct cost of producing what was sold. For a manufacturer, that means materials and factory labour. For a software company, it might mean hosting and customer support. Revenue minus cost of goods sold gives gross profit. Below that come operating expenses: salaries outside production, rent, marketing, research and development, and administration. Gross profit minus operating expenses gives operating income, the profit from running the business itself. Then come interest, the cost of borrowing, and tax. What remains at the bottom is net income, the profit that belongs to shareholders, which is why it is often called the bottom line.

A worked example makes the staircase easier to see. Here is a year for a small software company.

Raw numbers like these are hard to compare across companies of different sizes. A profit of 100,000 is excellent for a company with revenue of a million and poor for one with revenue of a billion. Margins solve the problem by dividing each profit line by revenue. Here, gross margin is 80 per cent, which is typical of software, where producing one more copy costs very little. A supermarket might have a gross margin in the low twenties, because most of what it charges goes to paying for the goods on its shelves. Operating margin is 15 per cent, and it is the margin I look at first, because it shows how well the whole business is run before decisions about financing and tax. Net margin is 10 per cent.

Margins become most useful when you watch them change over time. A falling gross margin usually means that the company is under pressure on prices, or that its direct costs are rising faster than it can pass them on. A falling operating margin while the gross margin stays steady means something different: overheads such as salaries, rent and marketing are growing faster than sales. The same headline profit can hide very different stories, and the margins are where those stories show up.

Operating income is, in my view, the most honest line on the page. Net income can be lifted by a one-off gain, such as selling a building or a division, and pushed down by a one-off charge, such as the cost of closing a factory or settling a lawsuit. Those items matter, but they do not tell you much about how the business will do next year. Operating income strips out most of that noise and shows what the core business produces.

Even operating income is an accounting figure, not cash. Under accrual accounting, a company records revenue when it delivers a product or service, not when it is paid, and it can book a sale today and collect the money months later, or in a bad case never collect it at all. Costs work the same way, in the other direction. That gap between profit and cash is the subject of the next lesson on cash flow, and it is why no one should read an income statement on its own.

When I read an income statement, a handful of questions guide me. Is revenue growing, and is it growing faster than costs? Are margins stable over several years, or do they swing in ways that need explaining? How much of net income comes from items that will not repeat? And if the company reports an “adjusted” profit alongside the official one, as many do, what exactly has been adjusted, and how far apart are the two numbers? Adjusted figures can be genuinely helpful, removing distortions that make a year look better or worse than it was. They can also be a way of persuading readers to ignore costs that are real. The difference is usually visible to anyone patient enough to read the notes.