Introduction to the Income Statement for Non-Finance Geeks
Concept
The concept of the income statement is actually pretty easy to understand and you're likely already familiar with it:
Sales - costs = income
It's just like your bank account. When you get paid from your job, that's like sales (or more formally, revenue). When you blow part of your income buying out your local Wal-Mart of all the purple hoodies and Bieber CDs, that's like costs (or more formally, expenses). Whatever is left over is your savings (or more formally, net income).
If you save this income from one pay period to the next, or one quarter to the next, then your bank account balance starts growing. The formal name for this concept is Retained Earnings, but that's located on the Balance Sheet, and is a post for a different day.
Structure
So let's start with the top of the income statement and work our way downwards. Every income statement is set up the same, top-to-bottom, and attempts to loosely organize the timing of creating and selling a product or service. As you move downwards you start taking away each of the costs associated with running the business until youre left with net income (or in some cases, a net loss).
Gross Profit
Gross Profit = Revenue - Cost of Goods Sold
Cost of Goods Sold (COGS) is a pretty apt description. It's how much it costs you to manufacture your product or deliver your service.
Imagine starting a RedBull stand on your street corner (What? Lemonade is boring and I need more caffeine.). Every time you sell a can of RedBull, you have to first buy that can or manufacture it yourself. If you buy it, you're going to want to purchase it at as low of a price as possible (e.g., wholesale), so you can then apply a "mark up" and make a profit by selling it for a higher price.
Advanced Note: from economic theory, the optimal mark up is equal to: 1/(elasticity of demand). The elasticity of demand is the sensitivity your customers have to your product's or service's price (i.e., how many cans of RedBull they buy if you increase or decrease the price). Again, pricing theory is the topic for another post.
Thus, if you buy a can of RedBull for $1.50 and sell it for $2.00, then your gross profit looks like this:
$2.00 revenue - $1.50 COGS = $0.50 gross profit
Gross Profit Margin
Margins are a way to compare two different-sized businesses in the same industry (higher margins are better).
In the example from above, our gross profit margin (GPM) is as follows:
$0.50 gross profit / $2.00 revenue = 25% GPM
A 25% gross margin business isn't one you want to start. Why? Because before you even wake up in the morning you've only got 25% of your sales price to work with.
To put this into perspective, professional services businesses typically have super high GPMs because the only cost of producing an incremental sale is the people's time. On the other hand, commodity businesses typically have very low GPMs due to the very cost intensive nature of gathering raw materials from their natural locations.
Operating Income
Next up are all the expenses associated with running the business. These are called operating expenses and include things like:
• Compensation and benefits
• Advertising and marketing
• Office space and supplies
You may have seen this crazy looking mnemonic before: EBITDA (pronounced ee-bit-dah). It stands for Earnings Before Interest Taxes Depreciation & Amortization, and is just a fancy way of saying operating income. After you remove all the expenses shown above, you're left with EBITDA.
Depreciation & Amortization
These words can seem intimidating but they actually represent the same concept. Let's compare this to when you purchase a car. You've may have heard the phrase, "cars depreciate but houses appreciate".
Depreciation refers to the fact that some assets reduce in value over time (e.g., cars and computers). Because they lose value, you need to account for this on the financial statements, by applying one of a few different methods. The most simple of these is called Straight-Line Depreciation. Basically, if the computer was purchased for $2,000 and won't be replaced for four years (referred to as the "useful life"), then you the the following:
$2,000 computer / 4 year useful life = $500 depreciation per year.
Attend of the four years, you're assuming the value of the computer will be $0. If it's not, then you need to account for its "salvage value". Assuming the salvage value is $400, you have:
($2,000 computer - $400 salvage value) / 4 year useful life = $400 depreciation per year
Amortization is the exact same concept, only it refers to debt like interest or finance charges, while depreciation is used to refer to assets like equipment.
Interest & Taxes
Ah yes, the wonderful world of debt and taxes. We probably don't need to get into taxation because it gets complex quickly. All you need to know is that accounting rules aren't an exact science so there are plenty of ways to legally manipulate accounting income to pay fewer taxes, if that's the financial strategy the CFO is perusing.
The other issue with taxes is that they're iterative (warning: you're about to go cross-eyed). That means that you calculate the tax payment based on income, which is after you've excluded all expenses. But, taxes are an expense too, so you have to keep calculating the tax expense, subtracting it from income, then calculating tax again. It's a paradox that's handled simply by hard-coding this expense after the first calculation.
Interest is can be interesting too (pun intended)! It's only an issue if the company has debt. If there are no loans, then there's no interest to pay (sort of like a house that's completely paid off). If there is debt, then it's broken out into short-term (i.e., less than one year) and long-term (i.e., greater than one year) debt. There's also what's called the "current portion of long-term debt", which just means the amount that's due in this fiscal year. Clearly, there are different interest rates for each loan that needs to be serviced, but the Interest line item collects all of it into one dollar amount.
Net Income
Easy. Add up all the revenue, subtract all the expenses, depreciation, amortization, interest, and taxes, and whatever is left is called net income. In the public company world, there's also a term called EPS (Earnings Per Share), which represents net income divided by the Common Shares Outstanding.
Net Income Margin
Similar to gross profit margin or operating profit margin, net income margin is equal to net income divided by revenue.
Retail clothing manufacturers (e.g., Guess) will have high gross profit margins (e.g., 70%), but low net income margins because it costs a lot to market and sell an item of clothing.
On the flip side, scalable Internet technology companies (e.g., Living Social) will have high gross margins and high net income margins. This is due to the fact that COGS of selling one more unit of software is $0 (it's already been developed, you just have to download it from the app store). Marketing costs, therefore, are typically the largest expense, outside of compensation and benefits, that a software company will have. This is why venture capitalists invest in technology companies, not in bars, restaurants, or retail stores. They're just not easily scalable.
