How to Read an Income Statement
Due diligence just might be the most important investing skill of them all. Without understanding how to research stocks, you might as well just try to grow your money at a roulette table instead.
A crucial part of due diligence is knowing how to read a company’s income statement. This document is loaded with useful fundamental analysis information on a stock.
Truth be told, income statements are fairly straightforward financial reports. But all of those numbers, columns and technical terms can be intimidating to a novice investor.
That’s why we’re walking you through the process of reading an income statement.
The Top Line: Sales and Revenue
For our purposes, sales and revenue are basically interchangeable. But you’ll often see one or the other because they represent different things.
“Sales” are direct transactions in which the company sells something to the public or a distributor. “Revenue” refers to any other income stream like royalties, franchisees or subscriptions.
Below is an example from an old McDonald’s (NYSE: MCD) income statement. As you can see, it has both sales and revenues.
The top line of an income statement leaves out a lot of important data. It doesn’t mention any costs or expenses, and it doesn’t tell you any per-share information.
Nonetheless, it’s the start of our calculations and is worth looking at. Many important metrics, like sales growth (aka increase/(decrease)) and price-to-sales ratio, are derived from the top line.
Operating Costs and Expenses
Next are the negative items: operating costs and expenses. These are divided into a few categories.
“Cost of sales” (also known as “cost of goods and services,” or “COGS”) measures how much the company spends to produce whatever it sells. For manufacturers, this is generally the cost of raw materials and labor. For service businesses, it’s the cost of providing that service.
After COGS comes “selling, general and administrative expenses” (or “SG&A”). These are the expenses associated with managing the company, not with its products. SG&A includes corporate payroll, legal, accounting and other general items.
Generally, analysts assume that a company’s management has strict control over SG&A. So if it seems to be shooting upward or is equal to a substantial chunk of total revenues, then that’s a red flag for the stock.
Once again, McDonald’s provides a good example of both types of expenses.
By subtracting total operating costs and expenses from total revenues (and/or sales), we get “operating income.”
We’re getting closer to the bottom line now. But we’re not quite there yet. There are a couple more items to get through first.
Interest and Taxes
Well, they’re pretty self-explanatory items. Corporations have to put aside money to pay off their debts and tax liabilities. These are separated from other expenses. They’re charged on operating income.
If a company is ponying up a big slice of its operating income to pay interest, that could be another red flag. Check the stock’s debt-to-equity ratio to see if it’s the result of overly aggressive borrowing.
In the McDonald’s example below, we also see some unusual items. At the time of this report, the chain had just sold off a former subsidiary, Chipotle (NYSE: CMG).
These expenses are the last to be deducted before the moment we’ve all been waiting for…
The Bottom Line: Net Income and EPS
We’ve finally gotten to the good stuff. “Net income,” also known as “total earnings,” is what’s left of operating income after all the deductions.
Divide that by the outstanding share count of the company, and we get “earnings per share (EPS).”
The EPS listed in quarterly earnings reports can make or break a stock. Analysts obsess over trying to predict the numbers.
These predictions are compiled into consensus EPS forecasts. Then, when the actual numbers come out, they’re compared to the analysts’ forecasts.
A stock tends to increase in price after an earnings beat, or a report that surpassed analyst forecasts. It tends to drop in price after an earnings miss, when EPS comes up short of the predictions.
Ultimately, all you need to understand an income statement is a fifth-grade-level understanding of subtraction and division. If you’ve got that, then you’re well on your way to developing great due diligence habits.