How to read an income statement

Revenue, also called sales or turnover, is everything customers paid for goods and services in the period. It is recognised when the company delivers what it promised, which is not always when the cash arrives.

Cost of revenue is what it cost to produce what was sold: materials, manufacturing, hosting, the labour tied directly to delivery. Revenue less cost of revenue is gross profit, and gross profit divided by revenue is the gross margin.

Gross margin is where pricing pressure tends to show first. A company forced to discount, or facing higher input costs it cannot pass on, usually sees it here before anywhere else.

Operating expenses are the costs of running the business that are not tied to a single sale: selling, general and administrative costs, and research and development. Gross profit less operating expenses is operating income, often close to what is called EBIT.

Operating margin is the clearest single read on how efficiently a business runs. It sits after the costs management controls and before interest and tax, which depend on how the company is financed and where it is taxed.

Interest expense, other income and tax come next, leaving net income: the profit attributable to shareholders. Net margin is net income divided by revenue.

Net income is where one-off items land — a gain on selling a division, a write-down, a legal settlement, a change in tax law. A sharp move in net income beside a steady operating income usually means one of these, and the notes will name it.

Earnings per share divides net income by the number of shares. Basic EPS uses the average number of shares outstanding through the period; diluted EPS adds the shares that options and convertible securities could create.

EPS can rise while net income stays flat, because repurchasing shares shrinks the number it is divided by. Reading EPS beside the share count shows which is happening.

A few habits make an income statement much more informative than a single year's figures suggest.

• Compare margins across several years rather than the level in one.
• Compare against similar companies, since margins vary enormously between industries.
• Treat adjusted figures in a press release as the company's own presentation. The income statement in the filing is the audited one.
• Compare a quarter with the same quarter a year earlier, because many businesses are seasonal.