Understanding Net Income
Perhaps the single most important measure of a company's profitability is net income. That's because generating profits is the most important responsibility that for-profit companies have to their shareholders. In fact, it's the very reason that many companies exist.
The best way to think about net income is in terms of profits. It's the money left over after all the expenses of the company have been subtracted from revenues. It's also important to understand the calculation of net income is prescribed by a variety of accounting rules, which are known as GAAP, or Generally Accepted Accounting Principles.
Because companies follow the same accounting rules when reporting of net income in their financial statements, it's easier for regulating authorities, such as the Securities and Exchange Commission, as well as investors to understand the financial health of a particular company. This standardization of reporting also allows investors to make direct comparisons between companies.
A simplified formula for calculating net income is as follows:
+ Revenues - Expenses = Net Income
The next several sections in this tutorial will explain each of the items appearing in the income statement in more detail. Later on, an example of an income statement will demonstrate how these components fit together.
The price paid by customers for the goods or services sold by a company are known as revenues. When a company sells these goods or services to a customer, they receive money in the form of cash or book credit sales to accounts receivable, which is money to be collected in the near future.
The revenues for any period of time are equal to the inflow of cash plus the increase in accounts receivable. Companies recognize or "book" revenue when the goods or services are delivered to customers. Revenues have a positive effect on net income.
The costs necessary to produce and deliver the goods or services to customers are known as expenses. It is the money expended by the company to obtain revenues; typically referred to as the cost of doing business. Examples of expenses include employee salaries, advertising, raw materials, shipping, warehousing, income taxes, as well as the decrease in the value of certain assets through depreciation.
Expenses have a negative effect on net income. The expenses reported for any period of time should be those incurred to produce the revenues associated with that same period of time. The accounting guideline that calls for aligning revenues and expenses is known as the matching principle.
Matching Revenues with Expenses
By aligning the expenses needed to generate revenues in a given period of time, the income statement more accurately reflects the appropriate level of profits associated with that same period of time.
For example, the reporting of annual net income should match the revenues for the year with the expenses associated with generating those revenues. This is why it's so important to recognize revenues when they're earned and expenses when they're incurred. When these two components of the income statement are matching, then net income for the period will be reported correctly.
Net income is usually reported as the final line item on a company's income statement. For now, it's important to understand that net income is a very good indicator of a company's financial health. The process for building an income statement will be discussed later on.
The operating section of the income statement is used to report the revenues and expenses associated with the company's primary business operations. The revenues and expenses appearing in this section provide the investor with an indication of how well the core operations of the company performed.
Net Sales or Revenues
Revenues, or sales, are the first items normally reported in the income statement. Revenues are all of the cash and credit sales; companies usually recognize revenues at the point their goods or services are delivered to the customer. If the company is reporting net sales, they are taking the total revenues received in a time period and subtracting from it any sales discounts, allowances, or returns.
Cost of Goods Sold
The cost of goods sold is the expense associated with the materials used to produce sales. The cost of goods sold can include raw materials or merchandise removed from inventory. If the items are typically shipped to the company's warehouses, then the account would also include freight charges or transportation-in costs.
These accounts include all of the costs associated with operating the company. Typically, operating expenses include costs directly related to selling goods or services, administrative, and general expenses; sometimes referred to as SG&A.
These are the expenses required to sell the company's product or service. Typical selling expenses include sales salaries and commissions, travel and entertainment, freight or transportation-out, postage, advertising, and all other costs the sales arm of the company might incur such as depreciation of sales equipment.
Administrative and General Expense
Typical administrative and general costs include the salaries of the company's officers, office worker salaries, legal services, insurance, utilities, depreciation expense on office equipment and buildings, stationary, and other office supplies. These are the costs associated with the administration of the company's operation.
Income from Operations
When all of the operating expenses mentioned above are subtracted from the net sales revenues, the resulting value is considered the income derived from operations. This is a very important item appearing on the income statement because it's a good indicator of how profitably a company is with respect to their principal business operations.
Companies can also realize revenues, gains, expenses, and losses that are not directly related to their principal business. These items are reported on the income statement outside of the operating section. These are either unusual items or they occur infrequently; not both, as discussed below in extraordinary items. The non-operating section is usually broken down into two subsections: other revenues / gains and other expenses / losses.
Other Revenues and Gains
This category includes revenues and / or gains, and these items are generally reported net of any related expenses. Once again, these are non-operating transactions such as dividend revenues or rental income.
Other Expenses and Losses
Just like the other revenues and gains, the other expenses and losses are reported net of any associated income and are non-operating transactions. The most common item appearing in this section would be interest expense on the company's bonds or notes.
Earnings Before Income Taxes
Also known as EBIT, this value provides the investor with a good feel for the income generated by operations, with consideration for some non-operating gains and losses. Some of the adjustments to income discussed later on will address events that happen very infrequently and are also unusual, such as extraordinary items and discontinued operations.
Income taxes appearing on the income statement include both federal and state level taxes.
Other Adjustments to Net Income
Sometimes companies need to report very unusual items. These are changes that don't happen very frequently, and are often "discounted" by market analysts because they are so unusual. They wouldn't normally be considered when evaluating a company's longer-term outlook. Adjustments falling into this category include:
- Discontinued Operations: Gains or losses on the sale of a portion of the business's operations.
- Extraordinary Items: Events which are both infrequent in nature and unusual.
- Changes in Accounting Principle: Any time a company changes an accounting method, such as inventory pricing or depreciation rates, it needs to explain, or disclose, the cumulative effect of that change on their income statement.
Simple Income Statement Example
If the analyst were to model all of the above mentioned items, the result would be an income statement for the company being evaluated. To demonstrate what a simple income statement might look like, the following example was assembled:
Comparative Income Statement
In the next article in this series, we're going to provide some guidance on the interpretation of the income statement and net income, which includes its link to earnings per share. Then we'll finish up with a more detailed explanation of how to put together an income statement, including some additional examples as well as spreadsheets that can be downloaded.
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