CHAPTER 1
The Income Statement

The income statement measures a company's profit (or loss) over a specific period of time. A business is generally required to report and record the sales it generates for tax purposes. And, of course, taxes on sales made can be reduced by the expenses incurred while generating those sales. Although there are specific rules that govern when and how those expense reductions can be utilized, there is still a general concept:

A company is taxed on profit. So:

However, income statements have grown to be quite complex. The multifaceted categories of expenses can vary from company to company. As analysts, we need to identify major categories within the income statement in order to facilitate proper analysis. For this reason, one should always categorize income statement line items into nine major categories:

1. Revenue (sales)
2. Cost of goods sold
3. Operating expenses
4. Other income
5. Depreciation and amortization
6. Interest
7. Taxes
8. Non-recurring and extraordinary items
9. Distributions

No matter how convoluted an income statement is, a good analyst would categorize each reported income statement line item into one of these nine categories. This will allow an analyst to easily understand the major categories that drive profitability in an income statement and can further allow him or her to compare the profitability between several different companies—an analysis very important in determining relative valuation. This book assumes you have some basic understanding of accounting, so we will just briefly recap the line items.

REVENUE

Revenue is the sales or gross income a company has made during a specific operating period. It is important to note that when and how revenue is recognized can vary from company to company and may be different from the actual cash received. Revenue is recognized when “realized and earned,” which is typically when the products sold have been transferred or once the service has been rendered.

COST OF GOODS SOLD

Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold by a company. These are the costs most directly associated to the revenue. This is typically the cost of the materials used in creating the products sold, although some other direct costs could be included as well.

Gross Profit

Gross profit is not one of the nine categories listed, as it is a totaling item. Gross profit is the revenue less COGS and is helpful in determining the net value of the revenue after COGS is removed. One common metric analyzed is gross profit margin, which is the gross profit divided by the revenue. We will calculate these totals and metrics for Amazon later in the chapter.

A business that sells cars, for example, may have manufacturing costs. Let's say we sell a car for $20,000, and we manufacture the cars in-house. We must purchase $5,000 in raw materials to manufacture the car. If we sell one car, $20,000 is our revenue and $5,000 is the COGS. That leaves us with $15,000 in gross profit, or a 75% gross profit margin. Now let's say in the first quarter of operations we sell 25 cars. That's 25 × $20,000, or $500,000 in revenue. Our COGS is 25 × $5,000, or $125,000, which leaves us with $375,000 in gross profit.

OPERATING EXPENSES

Operating expenses are expenses incurred by a company as a result of performing its normal business operations. These are the relatively indirect expenses related to generating the company's revenue and supporting its operations. Operating expenses can be broken into several other major subcategories, the most common of which are:

1. Selling, General, and Administrative (SG&A). These are all selling expenses and all general and administrative expenses of a company. Examples are employee salaries and rents.
2. Advertising and Marketing. These are expenses relating to any advertising or marketing initiatives the company employs. Examples are print advertising and Google Adwords.
3. Research and Development (R&D). These are expenses relating to furthering the development of the company's product or services.

Let's say in our car business, we have employees to whom we have paid $75,000 in total in the first quarter. We also have rents to pay of $2,500, and we ran an advertising initiative that cost us $7,500. Finally, let's assume we have employed some R&D efforts to continue to improve the design of our car that cost roughly $5,000 per quarter. Using the previous example, our simple income statement looks like this:

OTHER INCOME

Companies can generate income that is not core to their business. As this income is taxable, it is recorded on the income statement. However, since it is not core to business operations, it is not considered revenue. Let's take the example of the car company. A car company's core business is producing and selling cars. However, many car companies also generate income in another way: financing. If a car company offers its customers the ability to finance the payments on a car, those payments come with interest. The car company receives that interest. That interest is taxable and is considered additional income. However, as that income is not core to the business, it is not considered revenue; it is considered other income.

Another common example of other income is income from noncontrolling interests, also known as income from unconsolidated affiliates. This is income received when one company has a noncontrolling interest investment in another company. So when a company (Company A) invests in another company (Company B) and receives a minority stake in Company B, Company B distributes a portion of its net income to Company A. Company A records those distributions received as other income.

EBITDA

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a very important measure among Wall Street analysts. We will later see its many uses as a fundamental metric in valuation and analysis. It can be calculated as Revenue – COGS – Operating Expenses + Other Income.

It is debatable whether other income should be included in EBITDA. There are two sides to the argument:

1. It should be included in EBITDA. If a company produces other income, it should be represented as part of EBITDA, and other income should be listed above our EBITDA total. The argument here is that other income, although not core to revenue, is still in fact operating and should be represented as part of the company's operations. There are many ways of looking at this. Taking the car example, we can maybe assume that the financing activities, although not core to revenue, are essential enough to the overall profitability to be considered as part of EBITDA.
2. It should not be included in EBITDA. If a company produces other income, it should not be represented as part of EBITDA, and other income should be listed below our EBITDA total. The argument here is that although it is a part of the company's profitability, it is not core enough to the operations to be incorporated as part of the company's core profitability.

Determining whether to include other income as EBITDA is not so simple and clear cut. It is important to consider if the other income is consistent and reoccurring. If it is not, the case can more likely be made that it should not be included in EBITDA. It is also important to consider the purpose of your particular analysis. For example, if you are looking to acquire the entire business, and that business will still be producing that other income even after the acquisition, then maybe it should be represented as part of EBITDA. Or maybe that other income will no longer exist after the acquisition, in which case it should not be included in EBITDA. As another example, if you are trying to compare EBITDA with the EBITDA of other companies, then it is important to consider if the other companies also produce that same other income. If not, then maybe it is better to keep other income out of the EBITDA analysis, to make sure there is a consistent comparison among all of the company EBITDAs.

Different banks and firms may have different views on whether other income should or should not be included in EBITDA. Even different...