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301-The Income Statement
  Course 301:
  The Income Statement
  Though learning basic accounting may not be the most enjoyable exercise,
  knowing how to interpret a company's financial statements is critical to
  understanding how a business is performing as well as figuring out if a stock
  is a good value.
  
  In Lesson 107, we gave a basic introduction to financial statements. In this
  section, we will dig deeper and devote a lesson to each of the three main
  financial statements: the income statement, the balance sheet, and the
  statement of cash flows. Lessons 305 and 305 will help you use each of these
  statements to get a picture of a company's financial health and performance.
  
  First up is the income statement, which summarizes how the company's
  operations performed during a given period. It tells you how much money a
  company has brought in (its revenues), how much it has spent (its expenses),
  and the difference between the two (its profit). Did the company make a profit
  during the period? Did it improve its business over last year? The income
  statement will provide you with this information, and more.
  
  Next, we will walk through the different components of the income statement
  and illustrate how they may vary across different companies. By the end of the
  lesson, you should have a grasp of how to read an income statement, and you'll
  be able to test your knowledge by answering questions using a fictional
  company's income statement.
  
  
  Revenue
  While income statements for companies in different industries may not look
  exactly the same, almost all of them begin with the company's revenue for the
  period. Revenue, which is sometimes called "sales," represents the amount of
  money a company brings in for selling its goods or services. (Because banks
  and some other financial institutions make money from interest--i.e., they
  don't really "sell" anything--their income statements look different.)
  
  Depending on the nature of a company's revenue stream, a company will record
  revenue in one of several ways. When you buy a DVD from Best Buy BBY, for
  example, Best Buy recognizes revenue when you give the company your money or
  your credit card and walk out with your purchase. As another example, an
  insurance company will "recognize," or earn and record, revenue from premiums
  that you pay gradually over the period in which you are covered. Be sure to
  check out a company's "revenue recognition policy," which can be found in the
  notes accompanying its financial statements, to see how it accounts for its
  revenue.
  
  
  Expenses
  A company needs to spend money to make money, and these outflows from making
  and selling its products or providing and selling its services represent a
  company's expenses. Companies' expenses are usually grouped into similar
  categories.
  
  Cost of Sales. Cost of sales (also known as cost of goods sold--COGS--or cost
  of services) represents all of the expenses directly incurred in creating the
  goods or services that a company sells. Examples include raw materials, items
  purchased for resale, the cost of running a factory, and labor. If it cost
  Best Buy $9 to acquire the DVD that you purchased, that $9 is considered a
  cost of sales. The steel and rubber Harley-Davidson HDI had to purchase to
  make its motorcycles would also be grouped into cost of sales.
  
  Selling, General, and Administrative Expenses. Selling, general, and
  administrative expenses (also known as "SG&A") consist of several types of
  costs. Selling expenses are those expenses incurred in attempting to create
  sales for the company. Examples include marketing expenses and compensation
  for sales staff. General and administrative expenses, meanwhile, represent
  most overhead costs of operating a company's business. Costs related to a
  company's human resources and finance departments and costs related to its
  office buildings are examples of general and administrative expenses.
  
  Depreciation and Amortization. When a company purchases an asset that the
  company intends to use over a period of time, such as a piece of factory
  equipment or a building, the asset's entire cost isn't immediately expensed on
  the income statement. Instead, the company expenses the asset gradually over
  the estimated useful life of the asset. This expense represents the building's
  or equipment's normal wear and tear over time, and is referred to as
  depreciation expense.
  
  Amortization is similar to depreciation, except amortization relates to
  intangible assets, or assets that do not have a physical presence, such as a
  brand name. Oftentimes, depreciation and amortization are already included in
  the other expenses mentioned above, so you may not see them listed separately
  on the income statement. However, the statement of cash flows, one of the
  other key financial statements, has depreciation and amortization amounts
  (sometimes combined) disclosed.
  
  It is worth noting that depreciation and amortization expenses are noncash
  expenses. For more information about noncash revenue and expenses, read the
  section on accrual accounting later in this lesson.
  
  Other Operating Expenses. Other operating expenses represent all other
  expenses related to a company's primary operations not included in the above
  categories. Often, nonrecurring costs or accounting gains are included here.
  Pay close attention to these items. Some companies abuse these "one-time"
  accounting events to the point where they become annual events. Also, they
  frequently include items such as restructuring charges, which are costs
  incurred to close a factory or lay off part of the workforce, for example.
  They may also include asset write-offs or write-downs, which often suggest
  that management may have paid too much for a particular asset or invested too
  much in an unprofitable business.
  
  Interest Income and Interest Expense. In order to raise funds for the purchase
  of assets used to run the business, a company may issue debt (i.e., borrow
  money). In most cases, the company is required to pay interest on these
  obligations. Conversely, when a company has more cash than it currently needs
  for operating its business, it may invest this excess money. These investments
  often earn interest or investment income. On the income statement, you may see
  interest expense and interest income listed separately or lumped together as
  net interest expense or net interest income.
  
  Taxes. Just as you pay taxes to Uncle Sam, most companies do, too. For
  companies that make a profit, taxes are an expense on the income statement.
  
  
  Important Income Statement Calculations
  Now that we've talked about some of the major line items found on the income
  statement, let's discuss some of the important figures that are already
  calculated for us on it.
  
  Gross Profit. You actually won't find this amount on all income statements,
  but it is very easy for you to calculate yourself. Just take revenue and
  subtract cost of sales. Gross profit shows how much of a markup a company
  receives on the goods and services it sells. If you paid $12 for a DVD at Best
  Buy, and Best Buy's acquisition cost was $9, the gross profit Best Buy
  realizes is $3, or 25% of the sales price.

  
  Operating Income. Arguably the best indicator of a company's true performance,
  operating income is often called operating profit. It is calculated by
  subtracting cost of sales and all operating expenses (SG&A, depreciation,
  amortization, restructuring, and other operating expenses) from total revenue.
  Operating income measures the profit (or, in the case of poorly performing
  companies, the loss) that a company is able to generate through its main
  operations. Operating income is also sometimes called "earnings before
  interest and taxes" (EBIT) because those expenses are not considered
  "operating" expenses.
  
  Net Income. Net income is what's left over for a company after all expenses
  have been accounted for. It is sometimes referred to as a company's "bottom
  line." Many management teams and Wall Street analysts talk quite a bit about
  net income, but keep in mind that many types of items, such as one-time gains,
  can distort this figure. It is generally a poor proxy for a company's cash
  flow. And though net income is important, it should not be thought of as the
  end-all, be-all figure to focus on.
  
  Earnings Per Share. Earnings per share, or "EPS," is simply net income divided
  by the weighted average number of shares outstanding during the relevant
  period. (This number of shares is also listed on the income statement.) EPS is
  what management and Wall Street analysts seem to focus on most, since it is
  the profit left over for stockholders. While EPS can be a useful number, be
  sure to consider it in context with the company's other financial information.
  
  You'll notice that two EPS calculations are performed on the income statement:
  one for basic EPS and the other for diluted EPS. The difference is in the way
  the number of shares outstanding is used. The basic EPS calculation uses basic
  shares, which are the actual shares of a company's stock outstanding, as its
  denominator.
  
  Conversely, the diluted EPS calculation uses diluted shares outstanding, which
  takes into account securities that could be converted into common stock at
  some future point. Such securities include stock options issued to employees
  and convertible bonds. Using diluted shares is much more informative than
  using basic shares, because if and when these securities are converted into
  shares of common stock, your stake in the company, or your piece of the total
  pie, gets smaller and smaller.
  
  
  Accrual Accounting
  Chances are, at some point in your life you've subscribed to a newspaper or
  magazine. Most likely, the newspaper or magazine publisher asked you to pay
  for the cost of the entire year's worth of issues at the beginning of your
  subscription. However, when the publisher received your up-front payment, it
  was not allowed to record the entire amount of cash that you paid it as
  revenue.
  
  The above occurrence highlights the concept of accrual accounting, the
  accounting method used in the United States by publicly traded companies.
  Accrual accounting attempts to recognize revenue and expenses in the specific
  period in which they occur. For instance, accrual accounting recognizes
  revenue in the period in which the company sells its goods or actually
  provides its services. In our newspaper subscription example, the publisher
  recognizes revenue from your subscription gradually over the length of the
  subscription. So, in effect, the publisher is still recognizing revenue from
  your subscription weeks and even months after receiving your payment.
  
  Accrual accounting is also applied to reflect the purchase and use of a large
  piece of equipment or a building. When a company purchases such an asset, it
  does not record the entire cost of the asset as an up-front expense that runs
  through the income statement. Rather, it records the purchase price of the
  asset on the balance sheet. Then, each year, it takes a portion of that
  asset's cost and expenses it on the income statement as a depreciation
expense.
  
  Depreciation expense, which represents normal wear and tear for an asset (much
  as your car depreciates a little each year), reduces the recorded book value
  of the asset every year (very similar to how the value of your car goes down
  the longer you keep it). Keep in mind that depreciation is a noncash expense
  because the cash outlay already occurred when the asset was purchased and
  recorded on the balance sheet.
  
  Accrual accounting allows revenue and expenses to be recognized in the
  appropriate periods, letting a company match as best it can its sales with the
  expenses incurred in generating those sales. As you can see, cash in the door
  does not always mean immediate revenue for a company, and cash out the door
  does not always mean immediate expense for a company, either. Keep this
  important concept in mind as you analyze any company's income statement.
  
  
  The Bottom Line
  With this lesson, we've laid the foundation for how to interpret the numbers
  on an income statement to assess a company's performance and profitability.
  There is a lot of information in this lesson, so do not be afraid to read it
  more than once in order to absorb all the concepts. With the ability to
  analyze an income statement, you should get some sense as to how profitable a
  company actually is, a key consideration in deciding whether or not to become
  an owner in that company.