Understanding a Company's Income Statement

An income statement is another part of the financial statements that a listed company must release to the markets. These are provided in a company's Interim and Final Results documents and it essentially outlined a company's revenues and costs over a period of time. Once again, this is only really useful for company's that generate income, so it is not useful for Oil and Gas explorers, and Exploration-stage Miners (for example). The easiest place to start is actually with a photo of a company's income statement: in this instance, I have drawn upon Brightside Group's (LSE:BRT) 2013 Interim (Half-Year) Results. As shown, there is a comparison between June 2013 and June 2012's results as is typical, although for the purpose of this tutorial I will focus upon the column '6 months ended 20 June 2013'. You can find the relevant table for the company usually under a heading 'Income Statement' or in this case, 'Consolidated Statement of Comprehensive Income'.

The Components of the Income Statement

Brightside Group's Income Statement
Before starting, take note of the units in question. In this case all numbers are set as (£000's) meaning that all figures in the table actually need three zeroes added to them (i.e. they are in thousands).

Starting from the top, you have the company's Revenue which is all the money the company received over the 6 month period. For Brightside, that amounted to approximately £45.261m. Reading down, you then have the Cost of Sales - these are the costs incurred in selling the goods and are variable costs although costs such as wages of workers can be included as more output can mean more staff. This figure will be high for companies who are in the manufacturing sector as they have to buy raw materials and semi-finished products which are listed under this. Service-based companies, especially software companies, are likely to have much lower figures in comparison. For example, distribution costs and marketing would come under this subheading. Subtracting the Cost of Sales from the Revenue, gives you the company's Gross Profit.

Following on, you then have to subtract the company's Administrative Expenses which are the fixed costs incurred regardless of output. For example, this figure includes things such as the salaries of the board of directors and rent incurred. Other income can be a positive addition, but Brightside has not had any of these, so you need to subtract the Administrative Expenses from the Gross Profit. This gives you the Operating Profit.

From this, Finance Costs are subtracted, if they exist. These are costs from interest repayments and any costs arising from sorting out financing arrangements such as placings. Any Exceptional Items are then added into the equation. These are one-off costs or profits that may arise from restructuring a company, or selling a set of premises. In this case, the exceptionals were costs owed to a third party as part of a settlement arrangement. Taking the Operating Profit, subtracting the Finance Costs and adding Exceptional Items then gives you the Pre-tax Profit which totalled £7.516m for Brightside.

The final step is to take into account the tax rate which was 27% for Brightside. Do note though that this tax figure and Pre-Tax Profit figure is inherently rounded so the figures shown cannot be achieved should you wish to complete the same calculations as the exact numbers are not displayed. That is not an issue though. Once the tax rate is factored in, that provides the Post-tax Profit, which was £5.462m for H1 2013. This figure can then be divided by the number of shares in issue, to work out the Earnings Per Share, but refer to my tutorial on that for further information.

How is this useful?

The most obvious way in which this is useful is that you can compare the revenue and profit figures as time progresses. That allows you to track the performance of the company and see whether it is still growing. That is then useful when using the Earnings Per Share numbers. Moreover, it is important to understand how a company operates, and an Income Statement gives investors a glimpse of that.

courtesy of freedigitalphotos.net
Beyond the obvious, there are a few trends you can look out for. It allows you to make educated guesses about expected profit levels should tax rates change, or another of the components. Furthermore, one point I like to keep a look out for is how the Cost of Sales change over time. Remember that the Cost of Sales represents the variable costs. If you have a growth company that is increasing its revenues Year-on-Year by 25% then it is a very valuable figure as if the costs required to grow that revenue grow by 20% Year-on-Year then it implies the company is spending a lot of money in order to increase the revenues. If revenues are stagnant and Cost of Sales are increasing year-on-year, that could hint that the product is a hard-sell.

Alternatively, the Cost of Sales may increase due to increased marketing costs which are typical if a company is entering a new market - it gives investors a clue over how much money is needing to be spent, in order to gain market penetration. That can be followed off into the Administrative Expenses. If a company is entering a new market, they may have to set up a sales team, and purchase a building - those are shown under that category. In most circumstances though, investors in companies that are mature markets where revenues don't grow much, like to see falling costs as that is the contrasting way in which companies make profits - either growing revenues faster than costs, or cutting costs above the revenue movement.

Looking at the broken down Income Statement can also help investors understand why profit may have risen or fallen over a particular period with Exceptional Items giving an insight into how those key financials can be inflated or deflated slightly. Usually the company will point these out, but that is not always the case.

A useful ratios the gross margin. This is found via the formula below, and is a measure of the profit that a company makes relative to the revenue. Looking back at the above, you will notice the only difference between Revenue and Gross Profit is that the Cost of Sales is accounted for. Therefore this strips out that and gives it a meaningful number. The higher the Gross Profit, generally the better as it means the company has lower variable costs. The Gross Profit varies wildly between industries so make sure you do peer-peer comparisons as opposed to across industries.

Gross Margin = (Gross Profit / Revenues) * 100
 
Lets use Brightside Group as an example again. Before doing the calculations, it's good to have a general idea of what you would expect. Brightside Group is an insurance company so you would expect a high gross margin as the Cost of Sales are likely to be fairly low. That is the case. Using the figures:
 
Gross Margin = (32,476,000 / 45,261,000) * 100
  = 71.75%                
 
An important point to remember is that the Income Statement needs to be viewed in conjunction with the other parts of a financial report. For example, it would not tell an investor about whether the company has a large amount of debt because the interest rate might be quite small, meaning that the Financing Costs would not reflect that. In that case, you would need to search through the other parts of the report which will state if there are any large debts or other financing agreements in place. That is only one example of where an Income Statement is not useful on its own and remember, the accounting policy used can skew results if changed between years. Regardless, understanding and being able to interpret it is very useful for fundamental analysis.