“I call it the Rule of Three. If you read a company's financial statements three times, and you still can't figure out how they make their money, that's usually for a reason”
James Chanos
Hey everyone 👋🏼
“How’s this going to impact the bottom line?”
You’ve probably heard that one a few times in your career so far.
But do you really know what the bottom line is?! If you had to explain the income statement (P&L) of your business right now, could you?
In my early days of working, just the sight of a company’s income statement made me feel a bit queasy. Now, I'm on the other end of the spectrum; grabbing a copy of the most recent income statement is one of my first requests when I work with a company.
Because, if you’re curious to understand what’s making a business tick, knowing how to quickly get your head around an income statement and what to look for can make all the difference.
Today I’ll cover:
What is an income statement and what’s its purpose? 🕵️
A step-by-step breakdown of an income statement 🧩
Margins - and why gross margin needs to be your best friend 📈
What should you be looking out for? 🔎
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(Quickly) Explained…
The income statement is one of the three major financial statements (balance sheet and cash flow statement are the other two, which I’ll cover another day).
An income statement shows a company’s:
Revenue (Sales)
Expenditures (Costs / Expenses)
Net Income (Earnings, Profits)
Over a period of time i.e. a month, a quarter or a year.
What’s the purpose of income statement?
Ultimately, an income statement is an indicator of a company’s health.
It helps investors focus attention on:
Is the business making a profit? 😬
Is the business growing, declining or plateauing ?
Keeping an eye on trends 👀 - a way for management to analyze trends at a macro level
If you’re looking to figure out the health of the company you work for or you’re planning to invest in a company, getting an understanding of their income statement really should be your first port of call.
How to read an income statement: A step-by-step breakdown
Firstly, it’s worth bearing in mind that management teams have leeway in designing their income statement.
This means that not all income statements look the same.
But to get a flavor, here’s a typical layout using Amazon as an example:
Whilst statements will vary from company to company, a lot of the terminology remains the same. Let’s dive into the most important bits you need to know.
🟢 = income generating / profit
🔴 = expense
Key terminology you need to know
🟢 Net sales - Total value of all sales during the period.
🔴 Cost of goods sold - Costs associated with selling, such as materials and labor needed to build and sell your product.
🟢 Gross profit - This what we get after subtracting the cost of goods sold from net sales. This is before subtracting interests, overheads, taxes, and payroll
🔴 Operating expenses - This includes things like office rent, payroll, electricity, insurance etc
🟢 Net income from operations - The net operating income is the difference between gross profit and operating expenses. It represents the income from a company’s regular or main business.
🟢 Other income - Other income earned outside of core operations, such as money made through a sale of land or vehicles.
🔴 Other expenses - Companies can incur other non-operating expenses such as interest paid on borrowings and depreciation
🟢 Earnings before income tax - Other income is added to net operating income, and other expenses are subtracted. EBIT is considered the company’s future earnings indicator and hence closely monitored by financial analysts.
🔴 Income tax - The amount of tax that a company needs to pay to the government from the money they made.
🟢 Net profit - Net profit, also known as net income or the bottom line, is a measure of a company's profitability. It represents the amount of money a company has left over after deducting all its expenses from its total revenue. In simple terms, net profit is the money a company earns after paying for all its costs.
Grab a copy of this in a spreadsheet
Looking at the margins - why is it so helpful?
Margins make it easy to compare a company to itself or its competitors.
Small margin changes might not seem like a big deal, but they are, and it’s incredibly important to maintain unwavering surveillance on these metrics.
And, the one to keep a sharp focus on is:
Gross profit margin:
So if gross margin is not your final profit – why does it matter so much?
Gross margin tells you whether a company is making a profit on what they sell, or not.
Example
In this example, the gross profit on revenues of $150,000 is $50,000. This gives us a gross profit margin of 33% last year.
This year, our gross profit has shrunk slightly with profits of $100,000 on revenues of $450,000 which equates to a gross profit margin of 22%.
What if gross margin is negative?
When gross margin is negative, that means money is lost on each and every sale. So scaling up in that case means that instead of growing into profitability, you are actually deepening the loss with every sale.
On the flip side, a stable or rising gross margin is an incredibly positive sign. It signals that demand is healthy and the company has pricing power.
Things you should look out for:
🗓️ Time period - quickly scan the income statement for which time period it reflects
🤓 YoY view - the prior year view gives you a sense of how the company is performing over time
💰 Revenue - what direction is it going in: ⬇️ or ⬆️
% Gross profit margin: - similar to revenue, what direction is it going in: ⬇️ or ⬆️
💸 Expense categories - do they seem logical, is there anything amiss?
✅ Logical relationships between numbers - for example, at most companies, employee benefits (like health insurance, retirement plan contributions, parking passes) are a significant cost. If the salary line doubled but the benefits number went up by only 10 percent, that should strike you as odd.
Before I go…
Ever fancy running an ecommerce side hustle? Or instead of property flipping, ecommerce business flipping?
Find out how to buy a ready-made ecommerce store, why people sell profitable ecommerce businesses, success stories, the market landscape and more.
Thank you very much for reading 🙏 if you found this helpful and enjoyed the post, I’d be grateful if you could hit the ❤️ below - thank you! And if you have topics you’d like me to explain just hit reply and let me know.
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.