Part 2: Analyzing Financial Statements - Income Statement
A short overview of the three main financial statements for beginner knowledge.
This is a three-part series where I will go over each of the three main financial statements at a high-level. For those investing in individual stocks, you should be knowledgeable in all of these statements to understand the financial health and performance of a company.
In Part 1, we explored the Balance Sheet, which provides a snapshot of a company’s financial position at a specific point in time.
The Income Statement
Also known as the statement of operations or the profit and loss statement, the income statement illustrates a company’s financial position over a specific period. While the balance sheet is AT a point in time, the income statement is OVER a specific period, such as monthly, quarterly, or annually.
At its core, the formula is simple: Revenues – Expenses = Profits (or Losses).
Now let’s provide a more detailed breakdown.
Note: All the financial excerpts are of Home Depot’s (HD 0.00%↑) 2023 earnings report. Keep in mind that not all statements have the same sub-categories under these sections.
Revenues: The Money Coming In
Revenue: Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
These are mainly a result of the sales of goods and services that the respective organization sells.
Some organizations may even provide a further breakdown on their sale streams by product lines, geographic regions, or customer segments.
Expenses: The Money Going Out
Expense. Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
While the revenue section is very simplistic, the expense section can range from many things, such as cost of sales, selling, general, and administrative expenses, depreciation/amortization, interest expense, etc.
I will touch on some of the main components:
Cost of Sales, or Cost of Goods Sold - the costs directly tied to producing the goods or services such as raw materials, and manufacturing expenses.
Now, before we get into the other expenses, you need to understand Gross Profit. That is, revenues minus the cost of sales. This represents all of the profit before most of the fixed costs and can indicate how efficiently an organization produces its goods and services.
Operating Expenses - These are the sum of all the ongoing costs an organization expends to run its business. These expenses can include:
Selling, General, and Administrative (SG&A) - any costs related to compensation and benefits, rent, utilities, advertising, etc.
Research and Development (R&D) - any costs associated with developing new products or improving existing ones. For innovative companies, this holds significance.
Depreciation/Amortization - the allocation of costs from long-term assets over their useful life.
Once these are all deducted, operating profit (loss) is arrived at. This represents all the profit that an organization earns from normal business activities.
The final step to arrive at net profit (loss) is to deduct other expenses such as:
Interest - all costs related to the organization’s borrowings.
Taxes - all taxes owed to federal, state/province, and other foreign bodies.
Recall the retained earnings section from the equity section of the balance sheet? Well, the net profit or loss will then contribute to that area of the balance sheet. A net profit will increase retained earnings (i.e. equity), and vice-versa.
Stay tuned! In Part 3, we’ll explore the Cash Flow Statement, a critical tool for understanding how money moves in and out of a company. Please give a like and subscribe to be first in line to receive all of DiviStock Chronicles’ posts as soon as they are published. Thank you!
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