The income statement
The story of a period, told from the top line down. Read it backwards and you learn more.
The income statement answers one question: over a period of time, did more value come in than went out? It starts with everything that came in and subtracts its way down.
The descent, in order
- Revenue. What customers were billed for goods and services.
- Cost of goods sold. The direct cost of producing those goods and services.
- Gross profit. Revenue minus that direct cost. What is left to pay for everything else.
- Operating expenses. Research, sales, marketing, administration — the costs of running the business rather than making the product.
- Operating income. What the core business earned before financing and tax.
- Net income. What remains after interest and tax. The bottom line.
Why reading upwards is more useful
Net income is the most quoted figure and the most malleable. It sits below tax, financing, and a long tail of one-off items — restructuring charges, asset sales, legal settlements — any of which can make a poor year look fine or a fine year look poor.
A company's gross margin tells you what it can charge relative to what the product costs. That is closer to a description of competitive position than anything further down the statement, and it is much harder to flatter with accounting choices.
A worked example, entirely illustrative
| Line | Amount | As % of revenue |
|---|---|---|
| Revenue | $100 | 100% |
| Cost of goods sold | ($40) | 40% |
| Gross profit | $60 | 60% |
| Operating expenses | ($35) | 35% |
| Operating income | $25 | 25% |
| Interest and tax | ($7) | 7% |
| Net income | $18 | 18% |
Expressing every line as a percentage of revenue, as the third column does, is the single most useful thing you can do to an income statement. It makes two companies of different sizes comparable, and it makes one company comparable with its own past.