In analyzing the financial performance of a company, the income statement is where most
people spend a lot of time.
What is an income statement?
An income statement is an overview of how much a company has earned during a period.
The income statement is known under many names, each of these gives a hint of what we are
trying to review in this income statement tutorial: consolidated statement of earnings,
profit and loss statement, earnings report, statement of operations, statement of financial
performance, or simply: the income statement.
So in case you are unable to find the income statement for a company, try a search with
any of these other names!
Learning how to read an income statement is just like learning how to read anything else:
I encourage you to go through lots of real world income statements for companies that
you are interested in.
By reviewing the income statement, and the notes that come with it in the annual report,
you will at the same time learn a lot about how the business works.
Let me show you how to read an income statement, using the financial statements of Microsoft
as an example.
Microsoft is the company that developed the operating system Windows, whose latest version
is Windows 10, active on more than 900 million devices.
It is also very well-known for the Office suite of products, social network Linked In,
Azure cloud computing services, Microsoft Dynamics CRM and ERP solutions, Xbox gaming,
and Surface devices.
And those are just some of the highlights, as the company keeps innovating, transforming
and growing.
Let’s download the latest annual report.
In honor of Microsoft, we won’t use the Google search engine in the Google Chrome
browser for this, but Microsoft’s Bing search engine in the Microsoft Edge browser.
Either way, you will get to the latest annual report, which contains the income statement.
Here are Microsoft’s income statements for
(from left to right) fiscal years 2019, 2018, and 2017.
That’s the very first thing I verify in an income statement: how are the years ranked.
In this case, oldest year on the right, latest year on the left.
An income statement is an overview of how much a company has earned during a period,
so let’s verify exactly what period we are talking about.
Top left corner: for the year ended June 30.
So we are looking at fiscal years that start in July and end in June, rather than calendar
years that start in January and end in December.
To get a quick first impression, we take a look at revenue at the top of the income statement,
and net income at the bottom of the income statement.
Also known as the top line and the bottom line.
Net sales billed, and turnover, are sometimes used by other companies as a synonym for revenue.
Net earnings and net profit are sometimes used as a synonym for net income.
If CEOs or analysts discuss how revenue and net income have developed, they often refer
to top line growth and bottom line growth.
I am going to walk you through the entire income statement, starting with revenue.
One of the interesting things about Microsoft
is that it generates revenue from both products and services.
Actually, services have been growing so fast over the past years, that it’s almost a
50/50 split between the two for fiscal 2019.
How does a company recognize revenue?
That is such a complex and at the same time fascinating topic, that it deserves a separate
full-length video!
Here’s the main high level idea:
has the company delivered the product or performed the service.
The description of revenue recognition in Microsoft’s accounting policies states that
revenue is recognized upon transfer of control of promised products or services to customers.
For the moment, that’s what we need to know.
Next, we turn to cost of revenue.
If you accounted for the sale of products in the revenue section of the income statement,
then you must in the same period account for the costs of those products in cost of revenue.
If you accounted for the sale of services in the revenue section of the income statement,
then you must in the same period account for the costs of those services in cost of revenue.
The main idea of cost of revenue is that these costs tend to increase as the number of units
sold increases.
Not every element of cost of revenue is variable, and even those parts that are variable are
not necessarily proportionally variable.
Let’s look at some examples of cost of revenue for Microsoft.
Manufacturing and distribution costs for products sold and programs licensed.
Operating costs related to product support service centers and product distribution centers.
Costs incurred to include software on PCs sold by original equipment manufacturers.
Costs incurred to support and maintain online products and services, including datacenter
costs and royalties.
I think you’re getting the idea here: every piece of revenue from products or services
has a certain type and amount of cost related to it to deliver that product or service.
That’s what is accounted for in cost of revenue.
Next line item in the income statement is a profitability subtotal: gross margin.
Gross margin is revenue minus cost of revenue.
Microsoft has $83 billion of gross margin on $126 billion of revenue.
The gross margin percentage is 66%:
for every $100 of revenue, Microsoft earned $66 in gross margin.
Next section in the income statement is what most companies call operating expenses.
These are costs that do not directly increase as a result of the number of units sold.
The costs might increase year-over-year, but that is driven by management decisions to
allocate resources to its strategic priorities.
Microsoft splits this section into four line items, of which the first three are recurring,
and the fourth (restructuring)
only applies when there is an actual restructuring taking place.
Research and development expenses include amongst others payroll, employee benefits,
and third-party development and programming costs, associated with product development.
In fiscal 2019, R&D expenses for Microsoft were 13% of revenue.
Sales and marketing expenses include payroll, employee benefits, and other headcount-related
expenses associated with sales and marketing personnel, and the costs of advertising, promotions,
trade shows, seminars, and other programs.
14% of revenue in fiscal 2019.
General and administrative expenses include the headcount- and outside services related
expenses of functions such as finance, legal, facilities, and human resources.
4% of revenue in fiscal 2019.
This brings us to the next profitability subtotal: operating income.
Operating income is revenue minus cost of revenue minus operating expenses.
Or if you want to start from gross margin,
operating income is gross margin minus operating expenses.
Microsoft has $43 billion of operating income on $126 billion of revenue.
The operating income percentage is 34%:
for every $100 of revenue, Microsoft earned $34 in operating income.
A few more line items to go before we get to the bottom line of net income.
Other income, which for Microsoft is mostly driven by interest income and expense, and
net recognized gains on investments.
Why is this called “other” income?
Because it is income that does not come from a company's main business.
This income has to be recognized somewhere in the income statement,
this is the right place for it.
Next up is the provision for income taxes.
This is not necessarily the same number as the amount of cash the company actually transferred
during this year to pay taxes, but it is the calculated number of income tax expense on
the amount of income recognized in the line above.
As you see, the amount in provision for income taxes for Microsoft has fluctuated heavily
in the past three years.
This is mostly related to the change in US tax law, both structural and one-time effects.
For Microsoft in fiscal 2019, the effective tax rate was 10%, compared to the federal
statutory rate of 21% and the 55% effective tax rate in the prior year.
This brings us to the bottom line: net income.
Net income is revenue, minus cost of revenue, minus operating expenses, plus or minus other
income, minus provision for income taxes.
Or if you want to start from operating income, net income is operating income plus or minus
other income, minus provision for income taxes.
Microsoft has $39 billion of net income on $126 billion of revenue.
The return on sales percentage is 31%:
for every $100 of revenue, Microsoft earned $31 in net income.
This is what a financial analyst focuses on: the absolute amounts of revenue, gross margin,
operating income and net income, as well as their relative size versus revenue.
66% gross margin, 34% operating income, 31% return on sales.
Even though we reached the bottom line, the income statement does have additional important
information at the very bottom: Earnings Per Share or EPS.
This is calculated by taking the net income and dividing it by the weighted average number
of shares outstanding.
Out of the two EPS numbers on the page, basic and diluted, the diluted EPS is the one most
commonly looked at.
Diluted EPS has a higher share count in the denominator of the calculation, as the diluted
number of shares also takes stock-based awards into account.
Per share of stock, Microsoft earned $5.06.
This is an important input for people that use the price-earnings ratio in estimating
the value of a stock.
So that’s the income statement!
An overview of how much a company has earned during a period, all the way from top line
to bottom line.
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Thank you.