In this article, I will show you how to effectively read and analyze an income statement. This statement summarizes all revenues and expenses over a particular period, and is presented in quarterly (10-Q) and annual (10-K) reports. The purpose of an income statement is to show a company's financial performance over a particular period, which investors can then analyze to help determine the financial strength of a company. To comprehensively understand the income statement, I'll be going through the major line items in the income statement, discussing what's most important for investors, and will analyze the income statement of a real publicly traded company to determine its financial strength.
For this article, I'll be using the income statement from Verizon Communications Inc. (VZ) as an example. Its stock price performance can be seen in the chart below:
The income statement shows a company's financial performance over a specific period. In other words, the income statement shows how much revenue and expenses an entire business generated for operating their business over a specific period. This statement is also known as the profit and loss (P&L) statement, the statement of revenue and expense, or if you're looking at the official financial statements of a company (i.e., in a 10-Q or 10-K), it may be called the consolidated statement of income (or something very similar).
The primary objective of virtually every publicly traded company in the stock market is to generate as much profit as possible to maximize shareholder value. The income statement is therefore crucial to read and analyze as it shows what led to the profits being generated by a particular business.
You can locate the most accurate income statement of any publicly traded company in the U.S. by searching for it on SEC.gov, and looking under the "Financial Statements and Supplementary Data" category in the most recent 10-K annual report. You can also Google "company name + investor relations" and locate the most recent 10-K annual report from the company's website. Regardless, it's fairly simple to identify an income statement as it'll always have net sales (revenue) at the top and net income (earnings) near the bottom.
The income statement for Verizon's fiscal year (FY) 2020 is shown below, which I will reference throughout this article:
As you can see, the financial data on the income statement in a 10-K annual report will often show two or three year period values (2018-2020 in this case), and not just the most recent year's financial data. Regardless, the focus should be on the most recent fiscal year end, which in Verizon's case is December 31, 2020.
The income statement formula, in its most simplest form, is shown below:
Revenue - Cost of goods sold (COGS) = Gross income
Operating income = Gross income - Operating expenses
Net income = Revenue - Total expenses
The summary and brief description of what's inside the income statement is below:
The major components of the income statement are broken down and explained more (in order) below. Note that not all income statements will have the same exact name for every line item. In addition, these items usually contain subcategories and separate line items depending on a company's reporting and accounting policies. Typically, any further detail can be found in the footnotes of the financial statements.
Revenue (aka net/gross sales or income) is a top-line figure in the income statement that shows how money a business generated from product/service sales during a reporting period. Companies may choose to break down revenues by geography and/or business segments, with varying levels of detail and subject categorization.
Typically, revenue is only recognized on the income statement when the product/service has been delivered to the customer (when it's earned), and not when the money is received by the company. This differentiates it from the cash flow statement, which shows cash inflows and outflows over a reporting period. For some companies, there may little to no delay in recognizing revenue (i.e., traditional retail), while other companies (i.e., automobile and cruise companies) may have a larger delay. In addition, for companies that have long-term contracts, memberships, subscriptions, or similar revenue generation methods, revenue is recorded depending on the sum and duration (i.e., $60,000 for 1 year of service = $5,000/month recorded revenue).
Verizon breaks down its revenue into "Service revenue and other" and "Wireless equipment revenues," which is the revenue Verizon recognized over FY 2020. As you can see, Verizon managed to generate $128.292 billion in revenue over this period.
Cost of goods sold (COGS) (aka Cost of Sales) represents the component costs directly related to the sale of the company's products. For pure-service businesses (i.e., mobile apps), COGS does not exist, because there's no physical products being sold. Even if a business provides a combination of services and physical products to their customers, COGS (in its literal definition) only represents the physical component parts that are required to make whatever the business sells.
Because Verizon has two main revenue streams, it has decided to breakdown its COGS into "Cost of services" and "Cost of wireless equipment," at $31.401 billion and $19.800 billion respectively. Note that unlike many other income statements, Verizon decided to classify its COGS under the operating expenses instead, likely due to its business model and how service revenue makes up the majority of its total revenues.
The gross profit (aka gross income) formula is below:
Gross profit = Revenue - COGS
Gross profit is the profit a company makes after deducting any costs associated with producing and selling its products. Clearly, the greater/closer this figure is to total revenue, the better, as it means the company is producing its products at a lower cost.
Although gross profit is usually shown on the income statement, for Verizon it isn't. Therefore, we can solve for it instead and get $77.091 billion ($128,292 - ($31,401 + $19,800)).
Gross profit margin can be calculated as well, and gives us a better idea on the percentage of revenue that exceeds the COGS:
Gross profit margin = Gross profit / Revenue
For Verizon, this would be 60.09% ($77,091 / $128,292), which means Verizon maintained 60.09% of any revenue it recognized in 2020 after deducting the company's direct costs.
Operating expenses (OPEX) are expenses associated with the normal operations of the business. These expenses are related to operations, but are not directly tied to revenues. Operating expenses do not include COGS (i.e., direct labor, manufacturing, materials, etc.) or capital expenditures (i.e. buildings and machines).
More often than not, operating expense line items will differ depending on the company. Regardless, operating expense line item examples include selling, general & administrative (SG&A), depreciation and amortization (D&A), payroll, insurance, rent, equipment, inventory, research and development (R&D), office supplies, travel, and others. Ultimately, what's important is that the company you're analyzing keeps its operating expenses down. Obviously, this is because higher operating expenses means less profit for the company.
Much like revenue recognition, expenses don't appear on the income statement when a company spends money on the item or resource. It's only when this item or resource has been used up that an expense is recognized on the income statement. For example, if Verizon decided to pay their employees a total of $100 million upfront in January (for whatever reason), the cash outflow will appear on the cash flow statement, but on the income statement the expense for these wages will be evenly spread over the course of the year as Verizon's employees actually complete their work.
Verizon's operating expenses include "Selling, general and administrative expense" (SG&A), "Depreciation and amortization expense," and "Media goodwill impairment." Verizon's total operating expenses (without "Cost of services" and "Cost of wireless equipment") are $48.293 billion ($31,573 + $16,720).
The operating income (aka operating profit or recurring profit) formula is below:
Operating income = Gross profit - Operating expenses
Operating income therefore shows a company's profit after subtracting its COGS and operating expenses. It's therefore useful to investors as it doesn't factor taxes, interest, or any other one-off items that may skew net income.
Operating income is also very similar to what's known as "earnings before interest and taxes" (EBIT). However, EBIT also includes any non-operating income the company generates over the period, unlike operating income. Non-operating income simply refers to any company income that is not derived from the company's core business operations (i.e., investment income, write down of assets, interest income, foreign exchange gains/losses, sales of assets, etc). Note that if a company has interest income, this means the company is earning interest from investments it has made (i.e., savings account and certificate of deposit).
Verizon's operating income, as seen from its income statement, is listed as $28.798 billion.
The income before taxes (aka pre-tax income or EBT) formula is below:
Income before taxes = Operating income - Non-operating expenses
Income before taxes represents a company's profitability after all deductions, besides taxes, have been made against revenue. It deducts non-operating expenses, which are simply expenses incurred from activities not related to the core operations of the business. Examples of non-operating expenses include interest expense, losses from the sale of assets, write-off of intangible assets, restructuring expense, and anything called "other income/(expense), net" (or something similar). Note that interest expense is a sign that a company has debt, which is not uncommon, that the company has to pay interest on.
For Verizon, its EBT is called "Income Before Provision For Income Taxes" and equals $23.967 billion.
Net income (NI) (aka net profit, net sales, or net earnings) is the profit or loss ("bottom line") over the period, and it's the total revenue minus all of the expenses incurred during the period. Ultimately, this figure is an indicator of a company's profitability. Net income from the income statement will also flow to the balance sheet and cash flow statement as well.
Net income can also be calculated as follows:
Net income = Income before taxes - Taxes
For net income attribute to Verizon in FY 2020, this was $17.801 billion.
The earnings per share (EPS) formula is below:
Earnings per share (EPS) = Net income / Number of outstanding shares
EPS is a measure of profitability, and indicates how much in earnings a company makes for each share of its stock. A higher EPS therefore means that a comapny has higher profits relative to its share price, which indicates greater value. This figure is typically provided on the company's income statement, so you don't need to calculate this figure.
EPS is broken down into "basic" and "diluted" on the income statement:
As an investor, you should always use the diluted EPS number in your evaluation of a company, as it includes all outstanding shares PLUS potential shares.
To elaborate, this is because companies often compensate their managers with "convertible shares," which means that these managers will only receive the shares if the company's stock price reaches a certain price. Therefore, if the stock price performs well and these performance measures are met, these managers will receive these shares (which do not currently exist). Because there are more diluted shares outstanding, profit will be split between more shares, which reduces the EPS value. As a result, to be more conservative in your evaluation, it's recommended that you use the diluted numbers instead and assume that all potential shares will eventually be converted into actual shares.
In the case of Verizon, its diluted EPS is $4.30 ($17,801 / 4,142), as shown on the income statement.
To analyze an income statement, you can perform vertical and horizontal analysis to help determine the financial strength of a company. Obviously, the further back you analyze, the better overall picture you'll receive in regards to the company's financial performance.
Using Verizon as an example, I will begin by demonstrating how to complete a vertical and horizontal analysis, which can draw valuable financial strength insights. Then, I will discuss three figures (revenue, EPS, and net income margin) that I like to examine over the long-term (10 years) to better understand whether a company is worthwhile looking into further.
Vertical analysis is a top-down approach, where each line item is compared to total revenue as a percentage. This enables you to see relative proportions, which is useful when applied across multiple time periods and to compare between different industries/sectors and companies.
Completing a vertical analysis will therefore help you analyze where costs increased and decreased over a particular period, as well as which line items contributed the most to profit margins, among other things. Naturally, this may expose certain weaknesses and strengths the company may have, which you can then choose to look into further before making an investment decision.
To understand this better, Verizon's 3-year vertical analysis is shown below:
Clearly, vertical analysis can help when determining whether performance metrics are improving over time. Ideally, over time these expense items relative to revenue should be decreasing over time (including COGS which is not shown above), which in turn, will cause profitability and net income figures to increase.
Horizontal analysis may provide more use than vertical analysis, as it focuses on year-over-year (YoY) or quarter-over-quarter (QoQ) performance. Horizontal analysis therefore shows a company's consistency and growth over time. This can uncover trends and growth patterns in regards to the company's financial performance over time, which is why it's important to investors and analysts.
Note that percentage change can easily be calculated using the formula below:
Percentage change = [ (x2 - x1) / x1 ] * 100
Again, to understand this better, Verizon's 3-year horizontal analysis is shown below:
As you can see, this makes it easier for us to analyze how Verizon's revenue and expenses grew or fell over this period. Ideally, you'd want growing revenue and profitability metrics over time, and falling COGS and expense figures during this same period.
To get a better understanding of a company's financial performance, I like to analyze revenue, EPS (diluted), and net income (profit) margin growth over the 10-year period, which is essentially a horizontal analysis. Note that you can use QuickFS to quickly gather this 10-year data.
Net income margin is simply the relationship between the revenue and net income figure, and shows what percentage of revenue flows all the way down to net income. Its formula is below:
Net income margin = Net income / Revenue
Ideally, revenue and EPS should be growing at 10% or more per year for 10 years, with growth improving every year. Net income margin should be increasing steadily or be relatively stable over time, as this shows the company is consistent or becoming more efficient over time.
We can see Verizon's 10-year performance for its revenue and net income in the chart below:
As you can see, Verizon has relatively flat revenues over time, which has only grown 15.70% over the 10-year period (($128,292 / $110,875) - 1). Moreover, although its net income has grown over the long-term, it does not grow consistently. This may be a sign of a business with little to no economic moat, as those with a strong economic moat have returning customers, which leads to growing revenues, profits, and EPS.
This income statement analysis is further broken down in the image below:
As the table shows, Verizon has not been able to consistently achieve a 10% compound annual growth rate, which may not make it a worthwhile investment. After collecting 10-year data on revenue, EPS, and net income margins (i.e., with QuickFS), you can calculate this by using the RATE function on Excel or Google Sheets. For example, the 9-year annual growth for revenue from 2011-2020 would look like: =RATE(9 ,, -2011 revenue, 2020 revenue).
The table above can be shown in a chart as well:
As you can see, Verizon's financial performance has been slowing down recently, with revenues failing to grow strongly over time.
If EPS is failing to grow strongly or is shrinking, while revenue growth is strong, this is an indication of a company that is experiencing costs rising faster than the growth of revenues. Clearly, this is a company to stay away from.
On the contrary, if EPS is growing strongly, but revenue is not growing strongly or shrinking, this is an indication of a company that is effectively reducing its costs. This is a good sign, as it means the company is capable of lowering its costs to generate more in net income, even when revenue is not performing well. However, if this patterns persists for too long, this can harm the profitability of a company as the company is limited to reducing its costs to generate more in profits, which is not sustainable. Ultimately, this can limit a company's profitability, thereby likely making the company less attractive to shareholders.
In closing, the income statement shows how much revenue and expenses an entire business generated over a specific period. It's important that investors know how to analyze an income statement, as it can reveal the cost structure of a business, how effective it's at generating a profit, and can provide investors insight on what line items to look further into. Typically, any line items you don't completely understand will be discussed in the "footnotes of the financial statements" as well.
Investors can analyze an income statement by completing a vertical analysis and horizontal analysis. A vertical analysis will show expense and profitability proportions relative to total revenue, which is particularly useful to examine where costs increased/decreased, and to understand what line items contributed the most to profit margins. A horizontal analysis, on the other hand, shows a company's consistency and growth over time, which is useful when analyzing a company's financial performance.
Finally, investors can also look at the compound annual growth rates over the 10-year period for revenue, diluted EPS, and net income margin, in specific, to better understand a company's financial performance and whether it's a worthwhile investment.
Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.