Income statements are very important to all investors. However, if you are new to this, you might not know why. So, read on to find out why income statements are useful tools when it comes to making decisions.
The bottom line of every successful business is making a profit. So, if you are considering buying shares of a certain company, or if you are not sure if your current investment is working out, you will want to know how profitable they seem to be. And that is why looking at the income statement is important. With enough knowledge, the income statement will help you turn a profit with every trade.
What Is an Income Statement?
Well, before we even start answering that question, we should explain what income is. For any company or an individual, net income is the amount of money you get to “take home.” In essence, it is the money that is still there after all expenses are accounted for. And the income statement is the way companies figure out their profit numbers.
Some people also like to refer to the income statement as a P&L statement (profit and loss). After all, the net income can be either positive (profit) or negative (loss). That is why managers in internal accounting prefer to use the latter term. However, we prefer calling this statement an income statement as that is what SEC calls it.
So, to reiterate, the most crucial ability of a company is the ability to turn a profit. In the end, nobody wants to waste money on a company with negative net income. So, due to the nature of net income, the income statement is one of the most important aspects of trading. To put it simply – no matter how big a company is, the bottom line remains the same:
Profit = Revenues – Expenses
Revenue is the amount of money they bring in to the company, while expenses are the money they have to use to keep the operation going. The income statement will tell you what you need to know about those numbers.
And, sure, we know that some companies can be incredibly complex. However, the basic principle always remains the same. You get profit by subtracting your expenses from the overall revenues.
And, as a general rule, this is what income statements look like too, with slight variations. There are two kinds of income statements. The single step income statement and the multi-step income statement.
The former one follows the equation above to the letter. It is a very simple statement overall.
However, the latter type is a bit more complex. It actually differentiates between different kinds of activities. Namely, there are two kinds – operating and nonoperating activities. Operating ones are those that are fundamental to the business as such. So, if you are own a restaurant, the rent for the locale, the costs of making food and the revenue you bring are all operating activities. Nonoperating activities are pretty much everything outside of those. Of course, most publicly traded companies will use the multi-step statement.
What is Revenue?
Overall, revenue is the term that refers to the total amount of money a firm brings in. Of course, depending on the activities, some companies might refer to their revenues in different ways. Most commonly they speak of it as “sales.” Of course, there are other revenue items as well. The list includes rent revenue, interest revenue, and investment revenue.
The idea, however, always remains the same. Revenue is the amount of money the company can earn. Essentially, revenue is the gross income. You should also note that companies recognize the revenue they make as soon as they earn the money. For example, a company in the construction business will recognize the revenue as soon as they finish the job, even if they have to wait for a while to receive the money from the client. So, you should remember that even if the company has revenue, that doesn’t mean they have the money yet.
What Are Expenses?
The word “expenses” sounds self-explanatory. And it sort of is. The expenses of a company include everything that the company has to spend money on. Everything except investments – investments don’t count as expenses. But, back to the bottom line. The higher the expenses of a company are, the lesser the net income becomes.
However, understanding the expenses of a company can be a lot more important than just knowing the numbers. That is why a lot of income statements will separate the expenses by types. So, apart from general expenses, you will be able to see the expenses for research and development, the cost of goods they sell, and depreciation expenses.
Expenses can actually be a good thing for a company. Remember how you try to maximize your tax deductions every year? Well, companies like to do that too. So, instead of clinging on for the money, they will invest back into the company and grow the business.
Other Numbers
Income statements will usually include other items that can help you out. These advanced items can consist of comprehensive income or extraordinary items. You should, however, bear in mind that these don’t apply to every company out there. And, even if they do apply to a certain business, that doesn’t necessarily mean they are recurring. So, while it can be useful to know these numbers, you shouldn’t really treat them the same as the regular metrics.
Income Statement Analysis
Reading through the income statement is useful, but it will not do you a lot of good if you don’t know how to analyze it. So, we will help you out with that. Net income is something many refer to as the “bottom line.” But, what do you do with this number once you get it? How do you know if the number you are looking at shows promise or not?
Well, you should start by focusing on some important ratios and numbers.
Earnings Per Share – You might sometimes see it as an abbreviation EPS instead. You will usually find it right after the net income at the bottom of the statement. This number tells you the amount of income per share of the company’s stock.
Price To Earnings Ratio – Now that you know how much money each share makes, you should check the P/E ratio. You do this by dividing the price of the share by the earnings per share. That will help you understand how the stock is performing. It might even help you predict the movement of the company.
Margins – The margin of a company is the profit when you present it as a percentage of the revenue. Low margins of a company are usually a sign that the company is vulnerable to supply price increases. If you are planning to invest, seeking out companies with higher margins is usually the best way to go.
Of course, don’t just make your decision based on these numbers. However, you should definitely factor them in while making your decision.
Horizontal Analysis
While going through the income statement of a company, horizontal insight is also a good way to go. Essentially, you should check the income data over a period of time to get a better picture. So, if you see a company that has a net loss, but is closing in on a breakthrough and making a profit with each passing year, investing might actually be a really good idea. Alternatively, a company with a positive net income, but a downward trend, might start losing money in the following years.
Expectations
You should also consider the expectations. The management of the company will always try to predict how their income will behave in the future. And, while these are not always accurate, they can have a big effect on the value of the stock. For example, if a company performs far better than expected, the share of that company might rise.
The Conclusion
In the end, going through the income statement is essential while conducting a fundamental analysis of a company. So, make sure to learn how to be the one that makes a profit from the information in the income statement.
