This post continues the White Top View Series, Basic Numbers with Part 3, introducing financial statements for people new to investing. This post we discuss the bottom line on the income statement.
Links to the all parts of the White Top View Series, Basic Numbers are at the end of this post.
Getting to the bottom line on income statements
Income statements report how much revenue came in during the reporting period. On an annual report that period is a year but for the quarterly reports the numbers relate to the past three months.
The income statement is the “bottom line” report. It begins by showing all the revenue that came in during the period. Then it lists the cost of producing the product or service that generated that revenue. Listed below are all expenses incurred during the quarter or statement period.
Starting at the top, the revenue or total sales, is a positive number. Then all the costs of producing the product or expenses of running the business get taken away. Anything left over becomes bottom line. A positive number shows earnings. It tells us that revenues were able to more than cover all expenses. A negative number gives us the bad news of a loss! And that gets us asking more questions!
Get the most from an income statement, follow the money!
Follow the money by starting at the top of the income statement. That total revenue number should include all revenue from the operations of the business. Then work your way down the statement. Deduct each cost listed. Working your way, line by line, can give you great insight into what the company does well and does less well or poorly.
The first costs shown are any discounts or returns to show “net sales”.
Next the accountants show us the costs of producing the goods sold. That is the “cost of goods” number. Take it off and we end up with “gross profit”. In badly run or companies under great market pressure gross profit can be zero or less! Naturally we must ask for an explanation! Normally, we certainly do not want to invest in such a company and would move on without looking further.
Like any rule or guideline in business, there can be exceptions. For example a startup begins with no revenue but cost always immediately start. That means when you are looking at an income statement or any business for that matter, take common sense and good judgement with you.
Expenses need to be understood
Presuming we have a gross profit, we have to look further down the list of expenses to see if any revenue makes it to the bottom line. Before we get the profit we want, the bills have to be paid. The list shows all expenses or costs of every aspect of the normal operating costs of the business.
All costs incurred while running the business get deducted from the gross profit. Work your way down the list to gain a good feel of what costs are paid to keep that company running. Finally, anything left over gets to the bottom line!
Compare numbers year by year to understand the income statement message
As when we began looking at the balance sheet, having the numbers from the previous year made comparison to the earlier year easy. Here too on the income statement, we have numbers from the previous year for the same purpose. We can see changes and begin to understand where growth or erosion takes place. Drastic changes need clarification. Don’t hesitate to ask questions.
Dividing that bottom line number by the total number of shares gives us the “earnings per share” or EPS. That is the amount of money your share and each other share, earned by being invested in this company.
Choosing who gets the money, dividends or growth
When we receive dividends, normally it is portion of those earnings per share. Companies can’t give it all to us and stay in business. Management and directors use prudent decision-making when considering how much to pay out as dividends.
Companies need those profits to grow or to reinvest in the business to grow so we do not want them to distribute all the earnings. In high growth companies the best use of capital is growing the business and paying no dividends.
Examining the numbers and the ratios between them, as well as changes over time, provides much insight into the operations of a business. Doing so keeps many accountants, MBAs and analysts out to the bars. Their reports based on a deep examination or audit of the numbers, provides extremely useful information.
Apples, oranges, candlesticks and numbers
Comparing the numbers between companies in the same industry gives us further insight and understanding. We can readily compare between apple growers as they are much the same. Comparing an apple grower, seller or baker of apple pies are three distinctly different business. Consider how different retailing shoes, serving coffee, manufacturing drill bits and pumping oil differ as distinct business types.
Understanding the costs and operations of each let you compare them to decide what if the best investment for you. Doing so can find the best companies for us to invest in.
Comparing between companies in different industries or different business types can get complicated. To do that well, we have to learn about the normal practices and differences in those industries.
We can learn about and understand them all. We can do that by making a determined effort to become knowledgeable about each industry or type of business. Reviewing several sets of financial statements from similar companies and especially by asking questions, you can soon make that happen.
What about the cash
We certainly want bottom line but we also need to know where the cash comes from and gets used. We want positive cash flow! For that information we go to Part 4: Where did the money go? 1st look at cash flow which we discuss in the next post in this series.
“Share This” buttons at the bottom let you tell family and friends !
Subscribe free and get all new White Top View blog posts in your inbox!
Learn the White Top Investor website layout and organization, just click here for the Start Here Page.
Your comments and questions are welcome here. Or email me at WhiteTop@WhiteTopInvestor.com. Bite-sized White Top View posts are lessons to help non-investors on the way to becoming knowledgeable, comfortable, confident investors. By demystifying investing and giving you a better understanding of markets, one small step at a time, you can become the master of your financial security and independence. The White Top Views email list will never be shared or sold.
Have a prosperous day!
These discussions and information intend to help you better understand markets and investing. I am not a financial or investment advisor; opinions are for informational and educational purposes only and are not intended as investment advice. For syndication of the site or blog, please contact info@WhiteTopInvestor.com.
Images courtesy FreeDigitalPhotos.net
Links to the White Top View Series, Basic Numbers