The income statement is a financial document that reflects a company’s financial performance over a given period. It outlines the revenue earned and expenses incurred by a business during its operation within that timeframe.
Why bother learning how to read an income statement? This is one skill that all advanced investors know how to do; in fact, they know how to read it so well that income statement evaluations are simply a part of their process. Let’s learn how to read one and why it matters for your investing future!
Commonly referred to as the profit and loss (P&L) statement or the statement of revenue and expense, in official financial reports like 10-Q or 10-K filings, it’s often titled the consolidated statement of income or a similar variation.
For almost every publicly traded company, the primary goal is to maximize profits, thereby enhancing shareholder value. This makes the income statement indispensable for understanding the factors contributing to a company’s profitability. It’s essential for reading and analysis as it provides detailed insights into how a business has generated its profits.
The income statement formula in its simplest form is shown below:
Revenue – Cost of goods sold (COGS) = Gross profit
Operating income = Gross profit – Operating expenses
Net income = Revenue – Total expenses (including COGS)
This article will use Microsoft’s income statement as an example.
Revenue
Revenue, often referred to as the top line, is a crucial component of an income statement, representing the total income generated by a company from its business activities. In Microsoft’s case, this primarily encompasses income from various technology-based products and services.
- Product Revenue: This includes income from selling software products like Windows operating systems Microsoft Office Suite, and hardware like Surface tablets and Xbox gaming consoles. Microsoft’s product revenue directly reflects its market reach and product demand.
- Service and Other Revenue: Microsoft generates significant revenue from cloud-based services, including Azure and Office 365 subscriptions. Additionally, this category includes income from consulting and support services, advertising (through platforms like LinkedIn and Bing), and license fees from third-party vendors using Microsoft technology.
- Recurring Revenue: A growing portion of Microsoft’s revenue comes from recurring sources like software subscriptions and cloud services. This shift towards a subscription model, especially in cloud computing and software, provides a more predictable and steady revenue stream, reflecting a sustainable business model.
The analysis of Microsoft’s revenue streams on its income statement gives investors an understanding of the company’s financial health, market position, and growth potential. It also provides insights into Microsoft’s business strategy, like its focus on cloud services and subscription models, which are critical for long-term growth and stability in the technology sector.
Cost of Goods Sold
In an income statement, the Cost of Goods Sold (COGS) represents the direct costs of producing a company’s goods or services. For a technology company like Microsoft, COGS includes a variety of expenses directly tied to their diverse product and service offerings.
- Manufacturing Costs: For Microsoft’s hardware products like Surface tablets and Xbox consoles, COGS includes the materials and labor costs of manufacturing these devices. This encompasses everything from the purchase of components to the assembly and testing of the final products.
- Software Production Costs: For software products, COGS involves expenses related to software development. This includes costs for programming, testing, and software project management. Although software has a low marginal cost per unit, the initial development can be resource-intensive.
- Cloud Services Costs: A significant part of Microsoft’s offerings is cloud-based services like Azure. The COGS for these services includes the costs of maintaining data centers, energy consumption, and staffing for ongoing support and development.
- License and Royalty Fees: Microsoft also incurs costs related to licensing technologies and paying royalties, particularly for software products and digital content on its platforms.
Analyzing COGS in Microsoft’s income statement helps investors understand the direct costs of its product and service delivery. It’s a key metric that affects the company’s gross margin and overall profitability. For a diverse tech company like Microsoft, COGS reflects the costs of maintaining its competitive edge in hardware and software.
Gross Profit
Gross profit, a key figure on an income statement, represents the company’s income after accounting for the Cost of Goods Sold (COGS). It’s calculated by subtracting COGS from total revenue. For a company like Microsoft, understanding gross profit offers insights into its profitability and operational efficiency.
For example, Microsoft’s revenue includes sales from software products, cloud services, and hardware devices. The COGS – costs directly related to creating these products and services, like manufacturing costs for devices, software development expenses, and costs for running cloud services – are subtracted from this revenue. The resulting figure is Microsoft’s gross profit.
Operating Expenses
Operating expenses on an income statement are the costs associated with a company’s primary business activities, excluding the direct costs of goods sold. These expenses are critical for understanding a company’s efficiency and operational management. In the case of Microsoft, operating expenses offer a comprehensive view of how the company manages its regular business operations.
- Research and Development (R&D): A substantial portion of Microsoft’s operating expenses goes into R&D. This includes costs related to developing new software, enhancements to existing products, and innovations in technology sectors like artificial intelligence and cloud computing. Microsoft’s significant investment in R&D is crucial for maintaining its competitive edge and fostering future growth.
- Sales and Marketing: Another major component of Microsoft’s operating expenses is sales and marketing. This covers expenses related to advertising, promotional activities, and the cost of maintaining a global sales force. For a company with a wide range of products and services, these expenses are key to maintaining market presence and driving revenue growth.
- General and Administrative Expenses (G&A) include overhead costs forthe company’s day-to-day operations. For Microsoft, G&A expenses encompass executive salaries, legal and financial services, office maintenance, and other administrative activities.
- Depreciation and Amortization: These non-cash expenses account for the gradual wear and tear of Microsoft’s assets like equipment and software. Although not a direct cash outlay, they are important for understanding the company’s long-term asset investments and usage.
Analyzing Microsoft’s operating expenses provides insights into how the company strategically allocates its resources toward growth, innovation, and maintaining its market position. It reflects the balance Microsoft strikes between investing in future development and managing the costs of its ongoing operations.
Operating Income
Operating income is a crucial metric on an income statement, representing a company’s profit from its core business operations after deducting operating expenses. This figure is indicative of a company’s operational efficiency and profitability. For a tech giant like Microsoft, operating income provides valuable insights into its financial health.
Microsoft subtracts its gross profit to calculate operating income from its operating expenses – such as Research and Development (R&D), Sales and Marketing, and General and Administrative (G&A) costs.
Gross profit is derived from the company’s primary revenue sources, including sales from software products, cloud services, and hardware devices.
Microsoft’s operating income reflects its ability to generate revenue and manage the costs associated with its key operations.
Income Before Taxes
Income before Taxes = Operating Income- Non-Operating Expenses
Income before taxes measures a company’s profitability after accounting for all expenses, except taxes, from its revenue. This figure includes the subtraction of non-operating expenses, which are costs arising from activities not part of the company’s primary business operations.
Non-operating expenses can encompass items such as interest expenses, losses from asset sales, write-offs of intangible assets, restructuring costs, and other items typically categorized as “other income/(expense), net” or a similar term. The presence of interest expense indicates that the company is carrying debt, a common scenario, and is incurring costs in the form of interest payments on that debt.
Net Income
Net income, also known as net profit, net sales, or net earnings, is the final profit or loss figure for a given period, often referred to as the “bottom line.” It represents the total revenue of a company minus all expenses incurred during that period.
This figure serves as a key indicator of a company’s overall profitability. Additionally, net income from the income statement is carried over to the balance sheet and the cash flow statement, reflecting its integral role in a company’s financial reporting.
Wrapping Up…
Now, make sure to read the other new investor resources like How to Read a Cash Flow Statement and How to Read a Balance Sheet! Those two articles will round out your beginner education, so you’re on your way to becoming a savvier investor.
Enjoy!!