If you’re trying to break into investment banking or any field in high finance the very first thing you need to understand and have a firm grip on basic accounting. The language of business and financial modelling is accounting after all.
The Income statements is one of three financial statement (Income statement, Balance Sheet Statement and Cashflow statement) which companies prepare for investors and regulators to inform them of their financial health for a period of time.
This statement measures a company’s profitability or loss and records all revenue transactions made via both cash and credit and expenses both paid out in cash, IOU’s or “non-cash expense” over a period of time, this is usually months, quarterly or annually.
A side note, although the Income statement records and tracks revenue and expenses over a period of time, it is done so with a specific purpose in mind and that’s to calculate the taxable amount due to the authorities and ergo to get to net Profit.
The rule of thumb is, only item which will positively or negatively affect taxes belong on an income statement. For example, since interest is tax deductible, we therefore place any interest income or expense on the income statement but not the actual loan amount, as the loan has nothing to do with calculating tax.
Example of Financial statement
Starbucks
Tesla
Apple
Amazon
We are now going to dissect each component of an income statement starting from revenue and going all the way down to Net Profit and even calculating Earnings per share.
Revenue (Total Sales) – This is simply how much money the company has recorded as a result of trading for a period of time. The revenue here is from both cash sales and credit sales which has occurred within defined taxable period.
Cost of Goods Sold (COGs) – Direct cost associated with selling each unit of good or service e.g., raw material for assembling an iPhone. As revenue grows cost of goods sold will grow in proportion.
Gross Profit = Revenue – COGs
Selling, General & Administrative expense (SG&A) – The Indirect cost of manufacturing e.g. marketing iPhones or research and development. As revenue grows SG&A will not grow in direct proportion.
Other Operating Expense – these can sometimes be listed separately or be grouped up within SG&A, but common “other operating expense” line items are Advertising & Research and Development
Total Operating Income – Gross Profit less SG&A is the operating income. This is an important metric which can be used to compare individual companies within the same industry in regards to financial health and potential future returns. The average Operating income is dependant on industries, SaaS given the low cost based normally has 20%+ Operating income but other more mature industries have much lower operating income.
Operating Income can also be known as EBITDA ( Earnings before interest, Tax, Depreciation & Amortization) – this is a very common metric to compare like for like business and often used as the first starting point to get to Free cashflow.
Depreciation – From an accounting perspective the market value of the enterprise must be recorded and if the company bought a truck to deliver iPhones and after using the trucks the value of the trucks have gone down then the value by which the trucks and every other operating equipment must be recorded in depreciation. This has to be recorded as it reduces the taxable amount companies pay.
Amortization – This is similar to depreciation except it is for intangible items e.g. Brand names, Intellectual Property… etc.
EBIT (Earnings before Interest and Taxes) – EBITDA or Operating Income less Depreciation and Amortization is EBIT which is again another very common metric used to compare like for like companies within he same industry.
Interest – Given interest which are paid on loans are tax deductible, we have to include this on the income statement to make the appropriate adjustments. Interest is a very funny thing in the world of accounting, but essentially the reason is that interest is considered a cost of business so should be considered as an actual cost. However, interest earned increase the tax burden as taxes must be paid on that income.
Pre-Tax Profit – When you have EBIT and subtract Net Interest you are then left with Pre-Tax Profit. This is often used as a ratio for comparison.
Tax – Companies will have to make provisions for the appropriate amount of tax they will have tot pay in accordance to their tax jurisdiction.
Net income – Of course this is the main number which everyone is interested in as it shows how much money the company was able to keep after paying for all of its expenses and this is the amount which equity holders have a claim to. The net income figure, however does not mean this is the exact amount of cash the company has in the back. To see that figure (cash at bank) then you will need to refer to the cashflow statement.
Basic Earnings per share – This is simple the Net Income figure divided by the Basic shares outstanding which is essentially the number of tradable shares available the moment of calculation.
Diluted Earnings per share – This figure is similar to the above expect for the denominator is total shares outstanding in the market but also assumes options will exercised and thus reduce the number of shares outstanding in the market. By default this number will be smaller than above as it assumed less shares will be available on the open market.
Other line items which you will often see on the income statement
Other Income / expenses -these “other” income or expense line items are not part of operating income because they do not form part of the business’s core operations and its not a dependable source of income. For example, you can imagine a second care dealership will get their main source of income from selling cars, but they might get “Other Income” from car financing fees.
Non-recurring income and expenses – This is often regarded as one time or unexpected income or expenses e.g. environmental charge, restructuring cost, law suit or income from a law suit… etc. This is very hard to project because its unexpected and sometimes these can be very large line item e.g. pension related penalties…
Distribution – This is generally defined as payments to equity holders and is usually in the form of dividends or non-controlling interest payments. Think of it as company A owning a non-controlling interest in company B, company B will distribute a portion of profits back to company A as per the agreement in place.
The income statement tries to track expenses holistically, as a consequence also adjust for non-cash expenses like depreciation and amortization which does not truly reflect the actual (cash) expense. The only reasons why these non-cash expenses are on the income statement is because they provide a tax-deductible benefit and as a result accountants will always seek to maximise the depreciation amount in order to reduce the tax bill for the year.
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The income statement is part of the 3 financial statement used by investors and professionals to extract specific information for comparative purposes such as EBIT and EBITDA, Operating margins and Net Profit. Investment bankers use the income statement and other statements to build financial models for various reasons. Auditors will use the income statement to check if revenue and expenses have been correctly recorded for the specified time statement and that the numbers are accurate and sound. Tax regulators will use the income statement to measure the amount of tax which is due to authorities.