Note the word we used in the title to this chapter: code. Unfortunately, an income statement can often seem like a code that needs to be deciphered.
Here’s the reason. In books like this one—and even later in this book—you will often find cute little sample income statements. They look something like this:
| Revenue | $100 |
| Cost of goods sold | 50 |
| Gross profit | 50 |
| Expenses | 30 |
| Taxes | 5 |
| Net profit | $ 15 |
A bright fourth grader wouldn’t need much help figuring out that one, once she had a little help with definitions. She could even do the math without a calculator. But now check out a real-world income statement, like your own company’s. It’s likely to have dozens of lines, and you may wonder what each one includes. If you were looking at a detailed statement for a midsize or large company, it could go on for pages—line after line after line of numbers, usually in print so small you can barely read it. Even if it’s a “consolidated” statement like those you find in the annual reports of publicly traded corporations, it may contain at least a few lines with arcane labels like “conversion of subordinated debentures” (that’s from Johnson & Johnson). It’s enough to make anybody but a financial professional throw up his hands in dismay.
In this part we’ll help you understand the income statement’s secrets. And although your company isn’t a Johnson & Johnson, we’ll run through the whole drill, just as we promised; you will be able to decipher their income statements as well as your own. But mostly, we want to show you how the income statement can help you understand what is going on in your company and how to use that information to make decisions and lead your organization.
We’ll start by mentioning some simple procedures for curling up with an income statement. Boosting your financial intelligence shouldn’t involve an attack of heartburn, and learning these steps may save you from just that.
Before you even start contemplating the numbers, you need some context for understanding the document.
Accountants put labels at the top of every report they give you. Does the document say “income statement”? It may not. It may instead say “profit and loss statement” or “P&L statement,” “operating statement” or “statement of operations,” “statement of earnings” or “earnings statement.” Companies of all sizes use different language. We work with a client that calls the income statement in its annual report a statement of earnings. Meanwhile, one of the company’s major divisions calls its income statement an income statement—and another major division calls it a profit and loss statement! With all these terms for the same thing, one might get the idea that our friends in finance and accounting don’t want us to know what is going on. Or maybe they just take it for granted that everybody knows that all these different terms mean the same thing. However that may be, in this book we will always use the term income statement.
Incidentally, if you see “balance sheet” or “statement of cash flows” at the top, you have the wrong document. The label pretty much has to include one of those phrases we just mentioned.
If this is your own company’s income statement, it’s obviously for the entire business. If you were running a division of a large company, you might see income statements for the whole company, your division, its business units, maybe even its regions. H. Thomas Johnson and Robert S. Kaplan, in their classic book Relevance Lost, tell how General Motors developed the divisional system—with income statements for each division—in the first half of the twentieth century.1 Corporate managers are glad it did. Creating income statements for smaller business units has provided them with enormous insights into their financial performance. If your company has more than one store, plant, or branch office, you may want to see income statements for each one.
Next, check the time period. An income statement, like a report card in school, is always for a span of time: a month, quarter, year, or maybe year-to-date. Some companies produce income statements for a time span as short as a week. Now consider how the numbers are actually presented. Your own company’s figures are likely to be given just as they are: in thousands or millions. Big companies, however, usually omit the last zeros. So if you’re looking at one of their income statements, look for a little note at the top: “in thousands” (add three zeros to the numbers) or “in millions” (add six zeros). This may sound like common sense, but we have found that seemingly trivial details such as this one are often overlooked by financial newcomers.
Your company’s income statement is actual: it shows what “actually” happened to revenues, costs, and profits during that time period according to the rules of accounting. (We put “actually” in quotes to remind you that any income statement has those built-in estimates, assumptions, and biases, which we will discuss in more detail later in this part of the book.)
But there are also pro forma income statements, as they are known. Sometimes pro forma means that the income statement is a projection. If you are drawing up a plan for a new business, for instance, you might come up with a projected income statement for the first year or two—in other words, what you hope and expect will happen in terms of sales and costs. That projection is called a pro forma. But pro forma can also mean an income statement that excludes any unusual or one-time charges. Say you’re looking at the income statement of a company you’re thinking about acquiring. Now suppose that this company had to take a big write-off in a particular year, resulting in a loss on the bottom line. (More on write-offs later in this part.) Along with its actual income statement, it might prepare one that shows what would have happened without the write-off.
Be careful with this kind of pro forma! Its ostensible purpose is to let you compare last year (when there was no write-off) with this year (if there hadn’t been that ugly write-off). But there is often a subliminal message, something along the lines of, “Hey, things aren’t really as bad as they look—we just lost money because of that write-off.” Of course, the write-off really did happen, and the company really did lose money. Most of the time, you want to look at the actuals as well as the pro formas, and if you have to choose just one, the actuals are probably the better bet. Cynics sometimes describe pro formas as income statements with all the bad stuff taken out, which is how it sometimes appears.
No matter whose income statement you’re looking at, there will be three main categories. One is sales, which may be called revenue (it’s the same thing). Sales or revenue is always at the top. When people refer to top-line growth, that’s what they mean: sales growth. Costs and expenses are in the middle, and profit is at the bottom. (If the income statement you’re looking at is for a nonprofit, “profit” may be called “surplus/deficit” or “net revenue.”) There are subsets of profit that may be listed as you go along, too—gross profit, for example. We’ll explain the different forms of profit in chapter 7.
You can usually tell what’s important to a company—your own or any other—by looking at the biggest numbers relative to sales. For example, the “sales” line is usually followed by “cost of goods sold,” or COGS. In a service business, the line is often “cost of services,” or COS. If that line is a large fraction of sales, chances are you’ll want to watch COGS or COS very closely. But you better know exactly what goes into it. As we’ll see, accountants have some discretion about how they categorize various expenses.
(By the way, unless you’re a financial professional, you can usually ignore items like “conversion of subordinated debentures,” should you ever come across them on a public company’s income statement. Most lines with labels like that aren’t material to the bottom line anyway. And if they are, they ought to be explained in the footnotes.)
The consolidated income statements presented in public companies’ annual reports typically have three columns of figures, reflecting what happened during the past three years. Income statements prepared for internal use—your own—may have many more columns. Maybe your bookkeeper or accountant gives you something like this, for example:
| Actual % of sales | Budget % of sales | Variance % |
Or like this:
| Actual previous period | $ Change (+/ – ) | % Change |
These are pretty straightforward. In the first case, “% of sales” is simply a way of showing the magnitude of an expense number relative to revenue. The revenue line is taken as a given—a fixed point—and everything else is compared with it. Many companies set percent-of-sales targets for given line items and then take action if they miss the target by a significant amount. For instance, you might decide that selling expenses shouldn’t be more than 12 percent of sales. If the number creeps up much above 12 percent, you’ll want the sales manager to explain why. It’s the same with the budget and variance numbers. (“Variance” just means difference.) If the actual number is way off budget—that is, if the variance is high—that’s something else you’ll need to look into (more about variance analysis in the toolbox at the end of this part). Hopefully your managers are on top of it. Financially savvy entrepreneurs and managers always identify variances to budget and find out why they occurred.
In the second case, the statement simply shows how the company is doing compared with last quarter or last year. Sometimes the point of comparison will be “same quarter last year.” Again, if a number has moved in the wrong direction by a sizable amount, you will want to find out why.
In short, the point of these comparative income statements is to highlight what is changing, which numbers are where they are supposed to be, and which ones are not.
Chances are your company’s income statement won’t include footnotes. If it does, we recommend reading them very carefully. They are probably going to tell you something that the accountant thinks you should be aware of. Public companies’ income statements, like those found in annual reports, are a little different. They usually include many, many footnotes. Some may be interesting, others not so much. But they provide the details behind the company’s results. Depending on why you are reading the statement, those details may be of big interest to you.
Why so many? In cases where there is any question, the rules of accounting require the financial folks to explain how they arrived at their totals. So most of the notes are like windows into how the numbers were determined. Some are simple and straightforward, such as the following two footnotes from Nathan’s Famous, Inc.’s 2007 Form 10-K (the annual report required by the Securities Exchange Act of 1934):
Fiscal Year—The Company’s fiscal year ends on the last Sunday in March, which results in a 52- or 53-week reporting period. The results of operations and cash flows for the fiscal years ended March 25, 2007, March 26, 2006, and March 27, 2005 are all on the basis of 52-week reporting periods.
Interest Income—Interest income is recorded when it is earned and deemed realizable by the Company.2
But other footnotes can be long and complex, as suggested by the following footnote fragment from Build-A-Bear Workshop, Inc.’s Form 10-K for the fiscal year ending December 30, 2006:
Retail Revenue Recognition—Net retail sales are net of discounts, exclude sales tax, and are recognized at the time of sale. Shipping and handling costs billed to customers are included in net retail sales.
Revenues from the sale of gift cards are recognized at the time of redemption. Unredeemed gift cards are included in gift cards and customer deposits on the consolidated balance sheets. The company escheats a portion of unredeemed gift cards according to Delaware escheatment regulations that require remittance of the cost of merchandise portion of unredeemed gift cards over five years old. The difference between the value of gift cards and the amount escheated is recorded as a reduction in selling, general, and administrative expenses in the consolidated statement of operations.3
This particular footnote goes on for four more paragraphs. Don’t get us wrong: it’s important that Build-A-Bear Workshop explains its approach to revenue recognition. Decisions about when revenue is recognized are a key element of the art of finance. And don’t assume that Nathan’s Famous always has simple footnotes and Build-A-Bear Workshop always has complex ones. Our examples are simply to illustrate the diversity of the types of footnotes you’ll find relating to the income statement in an annual report.
In reading your income statement, you’ll want to be aware of some of the same material that public companies are required to put into their footnotes. Many you’ll already know, such as the specifics of your fiscal year. Others you may know are being handled, but you might not know the details. As you increase your financial intelligence, we recommend asking lots of questions of your accountant about where the numbers came from and the assumptions used. You may get a surprised (or frustrated) look, but in the end this is your business. If you are going to make decisions based on the numbers, you better understand how they were arrived at.
So those are the rules for reading. But don’t forget the one big rule that should be in the forefront of your thinking whenever you confront an income statement: Many numbers on the statement reflect estimates and assumptions. Accountants decide to include some transactions here and not there. They decide to estimate one way and not another. That is the art of finance. If you remember this one point, we assure you that your financial intelligence already exceeds that of many other entrepreneurs and businesspeople.
So let’s plunge in for a more detailed look at some of the key categories. If you don’t have another income statement handy, use the sample in appendix A for reference.