Understanding Income Statements

A lot of things hinge on a company’s profit. Profits determine bonuses, dividends to share holders, timely repayments to banks and an important measure to attract investors.

How is the income statement made?

By sales we mean the revenue the company makes by selling its products or services in the market.

Cost of Sales: This is the cost accrued to make the sale. This would include the cost of making the product sold, packaging cost, installation cost, sales training (to sell the product) and sales commission costs.

Gross Profit: The revenue a company earns minus the cost of sales is gross profit. The gross profit is used to pay operating expenses.

To arrive at gross profit:

Operating Expenses: All costs incurred to sell and produce the products are called operating expenses. These include:

  • Manufacturing and Research costs
  • Sales and Marketing
  • General and administrative expenses
  • Research and Development

Manufacturing and Research Cost: Let us take the example of the cement manufacturing company Grasim Cements. Every year, Grasim invests to develop new qualities of cement. Quick setting concrete is an innovation. Since one of their plants was in the vicinity of several thermal plants, they developed a new type of pvc cement incorporating fly ash in it. This turned out to be a big hit in the marketplace. Sometimes this exercise is also called product development. Grasim does this to introduce new variants in the market and differentiate itself from its competitors. The PVC variant commanded higher margins in the market.

Although all R&D does not always yield such successes it is an important tool of innovation that leads to profitability. The adage innovates or die holds true.

Sales and Marketing Expenses: In a newer fragmented market, customers are becoming more discerning in their purchases. So customers seek more information before a purchase. Grasim launched a mobile lab, which educated users by making site visits. This free service led to leads being generated and sales being made. Though this did not directly related to making a sale. Collecting information about the market through market research, test marketing, brand developments are other examples of marketing expenses.

Selling expenses include direct costs that help get the sale.

Tele-calling, trade shows, brochure distribution, advertising all form part of the sales costs.

General and Administrative Expense: Rent, staff salaries, employee welfare costs and other administrative costs form part of this title.

Operating Income: The earnings before interest or taxes is called the operating income. This is an important measure of profitability of the business. It is the difference between operating revenue and operating expenses. In the case where it does not include non-operating or non-business revenue, it is also called operating profit. A company’s earning potential before taxes, depreciation and amortization is called EBIT or EBITDA. It is a measure of the ‘pure’ profit of a company.

A business has other non-business related expenses. Interest expenses, loss or gain of revenue from its investments and sale of equipment.

In cases where profit margins from the core business is low, these ‘other expenses’ are an important element that affects profit. If this income is very large, it will be labelled as ‘extraordinary income’

Net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. Often referred to as "the bottom line" since net income is listed at the bottom of the income statement. In the U.K., net income is known as "profit attributable to shareholders.

In the case of publicly traded companies investors look for the net income per share, or Earning Per Share (EPS).When the net income is divided by the total number of shares, we get the value per share. This little number is used by investors and industry watchers a quick indicator of the company’s performance. Sometimes, when employees have stock options, they may choose to exercise them at a certain time, leading to the further division of the net income. This needs to be reported, so that prospective and current investors are aware there is a possibility of dilution of the EPS.

Companies use net income to measure their monthly performance against their budgets. This helps assess their performance and make required changes.