NEW YORK (TheStreet) -- Making a profit: It's the hallmark of a successful business. So whether you're thinking about buying stock in a company, or you want to make sure that a current investment is still a good one, the income statement is a really important thing to look at. Now let's take a look at how to make the income statement make a profit for you.
What's an Income Statement?
First of all, the question should probably be "What is income?" For a company, as with an individual, net income is "take-home" pay. That means it's the money that a company records as profit at the end of "the day." The income statement is the financial statement that's used to get to that oh-so-important number.
An income statement is also sometimes referred to as a profit and loss statement (P&L) because the net income can either be a profit (positive net income) or loss (negative net income). The term "profit and loss statement" generally refers to something used by managers for internal accounting, not for the financial statements that investors are interested in. As far as the SEC is concerned, it's called an income statement, so that's what we'll call it.
Again, a company's ability to turn a profit is paramount. Who wants to invest in a company that's losing money? Because of this, net income, the number at the bottom of the income statement ("the bottom line," see earnings), can have a dramatic effect on a company's stock price.
Revenues - Expenses = Profit!
In essence, companies get their profit (or income) by taking their revenues (money they bring in) and subtracting their expenses (money they spend).
Despite the complexity in many large companies' income statements, the same basic principle applies: Revenues - Expenses = Profit.
This is generally also the way income statements are set up. There are two basic types of income statements, the single-step and multi-step.
Singe-step income statements simply follow the equation of revenue minus expenses equals profit. For example:
A multi-step income statement is a little bit more complex in that it differentiates between operating and nonoperating activities. Operating activities are any activities that are core to a company's business. For example, if you own a clothing store, your clothing sales, store rent and manufacturing costs would all be operating activities. Nonoperating activities are anything else (this typically includes things like investment income or losses) that affects your store's income.
Most public companies use a multi-step income statement. To see a breakdown of a multi-step income statement, take a look at "The Finance Professor: How to Read an Income Statement."
What Is Revenue?
Revenue is the money that a company brings in. Depending on the type of company, revenue may also be referred to as sales, but the idea is the same: It's the total amount of money made by a company. For example, as an individual, your revenue is your (gross) income before taxes.
In addition to sales, common revenue items include rent revenue (if a company rents property to others), investment revenue and interest revenue.
Sales are reported net, which means that a company takes its total sales for the year and subtracts all of their product returns and exchanges. This produces a number that's representative of the company's true sales.
Companies recognize revenue after they do whatever they need to do to earn it -- regardless of whether they've actually received any cash yet. That means that if I own a construction company, I would recognize my construction revenue as soon as the job is complete, even if I'm still waiting on my check from the client. So while revenue means that I'm making money, it doesn't necessarily mean that I've got the cash in hand (or in the bank).
What Are Expenses?
A company's expenses include anything that the company is spending money on that's not an investment of some sort. Naturally, the greater our expenses, the less our net income will be. Some common income statement expenses include cost of goods sold (COGS), general and administrative expenses (G&A), depreciation expense and research and development expenses.
Expenses can be a good thing for some companies. Just as individuals want to maximize their deductions come tax time, companies whose value isn't derived from their income (usually those that are small and privately held) like to minimize their taxable income by spending money to grow the business. While the market value of a public company is ultimately affected by its income, companies want to maximize their net income by reducing expenses and getting as much revenue as they can.
There are other, more advanced, items that show up on income statements too. Things like comprehensive income and extraordinary items can be material on the profit or loss a company reports. Because both of these are out of the realm of "ordinary" business (and often don't recur), they shouldn't be counted for or against a company's income the same way that operating items would be.
How to Analyze Income Like a Pro
Net income (income after taxes) is often referred to as a company's "bottom line." This is both because it's such an important number, and, well, because it's usually the bottom line of the income statement. But once you have this all-important number, what do you do with it? How do you know what it's saying? What's respectable, and what's a red flag?
There are a few really important numbers and ratios that come from the income statement. Among them are the EPS, P/E ratio and margins.
EPS. Earnings per share (EPS) can be found at the bottom of the income statement as well, usually after net income. It's the amount of profit that is attributable to each share of the company's common stock. While it doesn't necessarily tell you what kind of dividends you might get for each share you own, it's a terrific metric that can be used to compare one company against another. (You can use the benchmarking tips in "Getting Started: Fundamental Analysis" to make sure that you're making good comparisons.)
P/E Ratio. The price-to-earnings (P/E) ratio is another great fundamental measurement. The P/E ratio (calculated by dividing the share price by EPS) can be used to try to figure out how over- or undervalued a company's stock is. If a company is trading at a high "multiple" (a P/E ratio that's much higher than others in its sector or industry), its share price might not accurately reflect the company's actual performance.
Margins. Margins (gross and net) are a way of looking at a company's profit as a percentage of revenues. A company with a low net margin (net income divided by its revenues) might be much more vulnerable to suppliers increasing their prices. Also, companies with higher margins don't need to sell as much to end up with the same net income.
Remember, though, none of these numbers or rates are absolute "investable" metrics -- just because a company has a poor P/E ratio doesn't mean that you shouldn't invest in it -- but it should definitely be a big consideration.
Horizontal Insight and Expectations
When you analyze a company's income statement, horizontal analysis (looking at a company's income statement data over a period of time) can also be very valuable. If you're looking at a company with a net loss that's been getting closer and closer to profit over the past couple years, you might be witnessing a turnaround that can make you some money. Likewise, if you notice a downward trend in income (or maybe just an upward trend in expenses), it's often going to be a red flag.
Another consideration is expectations. Analysts and company management make predictions about a company's income in advance to help give investors an idea about the future. These predictions aren't always that accurate (and should be taken with a grain of salt) but how close they are to actual results can have a big effect on a company's stock price. If a company reports a quarterly profit greater than expectations (or even a net loss below expectations), stocks can see some big upward movement.
Like the balance sheet, the income statement is an essential thing to look at in your fundamental analysis of a company. How much money that company's bringing in is a big deal -- and stock prices reflect that. So a company's income statement can have a positive effect on your income as well.
Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.