Reading an Income Statement

Before you even start contemplating the numbers, you need some context for understanding the document.

The Label

Does it say “income statement” at the top? It may not. It may instead say “profit and loss statement” or “P&L statement”, “operating statement” or “statement of operations”, “statement of earnings” or “earnings statement”. Often the word consolidated is in front of these phrases. With all these terms for the same thing, one might get the idea that our friends in finance and accounting don’t want us to know what is going on. Or, maybe they just take it for granted that everybody knows that all the different terms mean the same thing. However, that may be, in this course I will always use the term income statement.

Incidentally, if you see “balance sheet” or “statement of cash flows” at the top, you have the wrong document. The label pretty much has to include one of the above phrase I just mentioned.

What It’s Measuring

Is this income statement for an entire company? Is it for a division or a business unit? Is it for a region? Larger companies typically produce income statements for various parts of the business as well as for the whole organisation. H. Thomas Johnson and Robert Kaplan, in their classic book Relevance Lost, tell how General Motors developed the divisional system – with income statements for each division – in the first half of the twentieth century. We can be glad it did. Creating income statements for smaller business units has provided managers in large corporations with enormous insights into their financial performance.

Once you have identified the relevant entity, you need to check the time period. An income statement, like a report card in school, is always for a span of time: a month, quarter, or year, or maybe year-to-date. Some companies produce income statements for a time span as short as a week. Incidentally, the figures on large companies’ income statements are usually rounded off, and the last zeros are left off. So, look for a little note at the top: “in millions” (add six zeros to the numbers) or “in thousands” (add three zeros). This may sound like common sense, and indeed it is. But I have found that seemingly trivial details such as this are often overlooked by financial newcomers.

“Actual” versus “Pro-Forma”

Most income statements are “actual”, and if there’s no other label, you can assume that is what you’re looking at. They show what “actually” happened to revenues, costs, and profits during that time period according to the rules of accounting. (I put “actually” in quotes to remind you that any income statement has those built-in estimates, assumptions, and biases, which I will discuss in more detail later in this part of the course).

Then there are what’s known as pro forma income statements. Sometimes pro forma means that the income statement is a projection. If you are drawing up a plan for a new business, for instance, you might write down a projected income statement for the first year or two – in other words, what you hope and expect will happen in terms of sales and costs. That projection is called a pro forma. But pro forma can also mean an income statement that excludes any unusual or one-time charges. Say a company has to take a big write-off in a particular year, resulting in a loss on the bottom line. (More on write-offs later in this part). Along with its actual income statement, it might prepare one that shows what would have happened without the write-off.

Be careful of this kind of pro forma! Its ostensible purpose is to let you compare last year (where there was no write-off) with this year (if there hadn’t been that ugly write-off). But there is often a subliminal message, something along the lines of, “Hey, things aren’t really as bad as they look – we just lost money because of that write-off”. Of course, the write-off really did happen, and the company really did lose money. Most of the time, you want to look at the actuals as well as the pro-formas, and if you have to choose just one, the actuals are probably the better bet. Cynics sometimes describe pro-formas as income statements with all the bad stuff taken out, which is how it sometimes appears.

The Big Numbers

No matter whose income statement you’re looking at, there will be three main categories. One is sales, which may be called revenue (it’s the same thing). Sales or revenue is always at the top. When people refer to “top-line growth”, that’s what they mean: sales growth. Costs and expenses are in the middle, and profit is at the bottom. (If the income statement you’re looking at is for a non-profit, “profit” may be called “surplus/deficit” or “net revenue”). There are subsets of profit that may be listed as you go along, too – gross profit, for example. I’ll explain all of these in a later lesson.

You can usually tell what’s important to a company by looking at the biggest numbers relative to sales. For example, the sales line is usually followed by “cost of goods sold”, or COGS. In a service business the line is often “cost of services”, or COS. If that line is a large fraction of sales, you can bet that management in that company watches COGS or COS very closely. In your own company, you will want to know exactly what is included in line items that are relevant to your job. If you’re a sales manager, for instance, you’ll need to find out exactly what goes into the line labelled “selling expense”. As we’ll see, accountants have some discretion as to how they categorise various expenses.

By the way: unless you’re a financial professional, you can usually ignore items like “consolidated, liquidating securitisation entities”. Most line with labels like that aren’t material to the bottom line anyway. And if they are, they ought to be explained in the notes.