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How to Read an Income Statement

NEW YORK ( TheStreet) -- The most recent installment of the Finance Professor kicked off our look at how to start analyzing the financial statements of public companies. We covered where to locate a company's financial information and reports, and what to look for once you find this data. Now we're going to take the next step in this series of lessons and focus in on how to read a company's income statement (or profit and loss statement, the P&L).

Mind the GAAP

Income statements will vary from company to company and industry to industry. As such, the statement might seem like one big salad of information that we must learn how to sift through to better understand a company's operating results. However, there is one constant that always guides us in the preparation and understanding of financial statements such as the income statement. This constant is the application of generally accepted accounting principles, or GAAP.

GAAP is a standard that must be followed by all companies (public and private) in order to receive the unqualified independent auditor's report that I discussed last time. We rely on the auditor's report to confirm a company's adherence to GAAP or alert us as to the deficiencies of its financial statements in terms of accounting standards. Accounting standards are quite complex and in the United States are the responsibility of the Financial Accounting Standards Board (FASB). For the individual investor, it is more important to be assured that the company you hold in your portfolio is in compliance with GAAP than to understand the intricacies of the accounting standards.

A Look at McDonald's

With the aforementioned in mind, I will start by using a rather simple form of income statement from a company that I know quite well: McDonald's. Below, I have included a copy of McDonald's income statement, which I extracted from the company's 2006 annual 10-K:

McDonald's Corp.(MCD)
Click here for larger image.
Source: McDonald's Corp.

Section by Section

Let's first start in the top section of this income statement, with revenue (or income). Please note that within revenue you have two different classifications: sales (e.g., "Sales by Company --operated restaurants") and revenue (e.g., "Revenues from franchised and affiliated restaurants.") While sales and revenue might seem like identical terms and are frequently used interchangeably, there are some subtle differences to be aware of.

Sales vs. Revenue

Some companies act as direct sellers to the public and, concurrently, as suppliers to wholesalers or other distributors. Other companies use franchisees to distribute their product. Sales represent direct sales to the public or distributors. In McDonald's case, these are sales that McDonald's makes at company-owned restaurants. Revenue represents income streams from nondirect or ancillary sources. For McDonald's, this would be fees earned from franchisees that operate their own McDonald's branded restaurants.

For another take on the difference between sales and revenue, let's take a quick look at BJ's Wholesale Club. BJ's direct sales to customers would be viewed as sales, while the fees it earns from its members' annual membership dues would be viewed as a revenue item.

Operating Costs and Expenses

The next section of the income statement deals with a majority of the costs and expenses associated with the operation of a company's business. The description of such expenses will vary from company to company, but we can divide them into several general categories:

Cost of Sales:

This line item represents the expenses incurred by the company to produce and deliver the product or service to the customer. For McDonald's, this would include, but is not limited to, the cost of its hamburgers, French fries, beverages, labor, utilities, occupancy (rent and depreciation) and paper goods. A retailer such as CVS Caremark describes these costs as "costs of goods sold, buying and warehousing costs."

Selling, General and Administrative Expenses (SG&A):

These are expenditures related to the management of the overall company, which cannot be directly linked to product sales or the delivery of services. This will include items such as corporate overhead, legal, accounting,Sarbanes-Oxley compliance, management, stock based compensation, advertising, marketing, travel, entertainment and licensing expenses.

Depreciation:

This represents the expensing of asset costs over a prolonged period of time. For example, McDonald's might build or buy a structure to house a company-owned restaurant. That cost is first capitalized and then expensed in piecemeal fashion over a period of time. Some companies, such as McDonald's, might actually consider this a cost of sales. Other companies might break this out separately as another line item under operating expenses.

Amortization:

This cost is similar to depreciation except that it relates to the expensing of intangible items over a period of time. Intangible items include goodwill and intellectual properties, such as trademarks or licenses. Goodwill represents the excess of the purchase price over the book value of a company when one company acquires the other.

Operating Income

When we subtract total income (revenues plus sales) from total operating expenses, the difference represents operating income. This amount tells us how successful or not a company has been in executing its business plan to profitably sell its products and services.

Interest

Next to be presented in the income statement is the interest section. There are two types of interest: revenue and expenses. Most companies will net these two interest streams together and present them as "net interest." On the other hand, some companies, including banks, broker-dealers and financial institutions such as Citigroup and Merrill Lynch, which rely on interest as one of their core revenue streams, will present net interest as a part of revenue, thus incorporating those items within their operating income.

When we take operating income and subtract net interest (or other items), we will arrive at earnings before income taxes (or EBIT, which should not be confused with EBITDA). As I mentioned in an earlier article, Ben Franklin was quoted as saying, "In this world nothing can be said to be certain, except death and taxes." This holds true for the corporate world as well. Thus, we must next calculate the provision for income taxes and present it in the income statement. This leads us to another aspect of the real world that must be explained.

Provision for Income Taxes

Under GAAP, a company must make a calculation or provision of the amount of income taxes owed based upon the company's GAAP results. This amount may differ from the actual taxes paid to federal and local governments. For the purposes of the income statement, the provision is presented. In terms of cash flow and balance sheet statements, taxes owed or paid are factored in relative to the provision. (The cash flow and balance sheet statements will be covered in the upcoming weeks.)

The Bottom Lines: Net Income and EPS

When we subtract taxes from EBIT we arrive at net income. If we divide net income by the total diluted outstanding share count of the company, we get earnings per share (EPS).

Other Wrinkles and Their Impact on EPS

There are two additional financial wrinkles that we need to consider when looking at EPS: discontinued operations and nonrecurring items.

Discontinued Operations:

From time to time, a company will sell or spin off a business or close down a subsidiary. When this occurs, the company will segregate the net income attributed to these divisions or products as income or as a loss from discontinued operations.

The impact to EPS for discontinued operations is separated from net income to arrive at net income from continuing operations.

Nonrecurring Items:

On occasion, one-time nonrecurring items, which benefit or negatively impact the company's results, are incurred. These items are typically highlighted and separated because they do not represent an aspect of continuing operations of the company.

The impact of nonrecurring items is not separated on the income statement but is frequently disclosed in press releases, conference calls and notes to financial statements. Why? To help the income-statement reader filter out these items, which may materially impact the company's EPS but are not as relevant to the continuing operation of the company for comparative purposes.

This week's homework:

  • Obtain an income statement from two of the companies discussed in this lesson (McDonald's, BJs, CVS Caremark, Citigroup, Merrill Lynch) and an income statement from one of your own current (or potential) individual stock holdings.
  • Compare and contrast the financial presentations from company to company and industry to industry.
  • Become familiar with the unique line items presented in the income statements per company and per industry.
  • Understand what is driving the EPS for each company.
  • Ascertain the source of discontinued operations or nonrecurring items.

At the time of publication, Rothbort was long BJ, C, CVS, MCD, and MER (with calls), although positions can change at any time.

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