If you follow the stock market at any level, you’ll often hear discussion about a company’s profitability. All publicly traded corporations are required to provide income statements which detail the company’s revenues and expenses. The income statement, which is issued on both a quarterly and annual basis, allows investors to take a closer look at the company’s overall financial performance, including the company’s profit picture.
So, what is a company’s profit margin? The profit margin is the net income (revenue minus expenses) divided by the net revenue. This ratio allows investors to understand how much a company is earning in relation to their overall revenues. Even novice investors can easily use the income statement to determine the profit margin and examine the company’s financial performance. These numbers can be somewhat intimidating at first, but investors can quickly become accustomed to the terminology involved in reading income statements.
As the first part of the income statement, the company will provide revenue or sales data. Next, the income statement details the company’s operating expenses. Cost of Goods Sold (also known as COGS) comprises all expenses directly related to the creation of a product or service. You may or may not have heard the term gross profit – this would be the measure of how much a company earns after making the product, but before taking any other costs into account. The gross profit can be determined by subtracting the Cost of Goods Sold from the revenues and dividing by the revenues. Other operating expenses include Selling, General, and Administration (SGA) costs, Research and Development, Depreciation, and Amortization. All of the operating expenses are subtracted from the revenues to come to the operating income. Next, non-operating expenses (or income) such as interest expense (or income) are subtracted (or added) to the operating income to come to the income before taxes (this is sometimes known as EBIT, or Earnings Before Income Taxes). Finally, income tax is subtracted from the income before taxes to come to the net income, with profit margins derived from the net income divided by the net revenue.
Once you understand what the numbers on the income statement mean, you can analyze the results fairly quickly. You can use the income statement to see whether the company has strong gross and net profit margins (a strong gross profit margin is typically above 50%, while a strong net profit margin will vary by industry). In analyzing the individual values of the income statement, you’ll want to look at quarterly and yearly trends for each value. For example, are overall expenses increasing faster than revenue? If the company states that they are cutting production costs, is the Cost of Goods Sold decreasing? Is the company’s revenue growing, and at what pace is it growing? Many large corporations with multiple divisions will break down profit performance by area so that investors can better understand the profitability for each division.
The income statement will give only part of the picture – you’ll want to look at the company’s balance sheet and other financial statements before making a final decision on whether or not you want to invest in the company. However, the income statement will give you a good start in understanding the financial performance of any company.