Reading an Income Statement: Revenue, Earnings, EPS and Profit Margins

The income statement shows how much a company sold (revenue), what it spent to make and sell its products and run the business, and what was left as profit (net income or earnings) over a quarter or a year. Earnings per share (EPS) divides that profit by the number of shares, and profit margins show how much of each dollar of sales turns into profit. Compared over time and against competitors, these few numbers tell you whether a business is growing and how good it is at making money.

Where to find the numbers

US-listed companies publish an annual report on Form 10-K and quarterly reports on Form 10-Q, filed with the SEC and free on its EDGAR database and on each company's investor relations website. Foreign companies listed in the US usually file an annual Form 20-F instead (see ADRs). Companies also issue a short earnings press release with the headline numbers. Note that some companies' financial years do not match the calendar year.

The income statement, line by line

Here is a simplified income statement for an imaginary company, Northbridge Tools, for one year (figures in millions of US dollars).

Line	Amount	% of revenue
Revenue	10,000	100%
Cost of revenue	(6,000)	60%
Gross profit	4,000	40%
Research and development	(800)	8%
Selling, general and administrative	(1,200)	12%
Operating income	2,000	20%
Interest expense	(200)	2%
Pre-tax income	1,800	18%
Income tax (21% assumed)	(378)	3.8%
Net income	1,422	14.2%
Diluted shares	500
Diluted EPS	$2.84

What each line means:

• Revenue (sales, the "top line"): money earned from customers in the period.
• Cost of revenue (cost of goods sold): the direct cost of making the products or delivering the service.
• Gross profit: revenue minus cost of revenue.
• Operating expenses: research and development (R&D) and selling, general and administrative costs (SG&A), such as salaries, marketing and offices.
• Operating income (roughly EBIT, earnings before interest and taxes): profit from the core business.
• Interest expense: the cost of the company's debt.
• Net income (earnings, the "bottom line"): what is left for shareholders after everything, including tax.

Profit margins

Margin	Formula	Northbridge
Gross margin	Gross profit / revenue	40%
Operating margin	Operating income / revenue	20%
Net margin	Net income / revenue	14.2%

Margins only mean something compared with similar companies and with the company's own history. A software company can have gross margins above 70% because copying software costs almost nothing, while a supermarket may run on net margins of a few percent and still be a fine business. A margin that rises year after year often signals pricing power or scale; one that keeps falling can signal competition.

Growth and operating leverage

Compare quarters year over year (this year's third quarter against last year's third quarter). Many businesses are seasonal, and a quarter-to-quarter comparison can mislead.

Earnings per share (EPS)

EPS = net income (less any preferred dividends) / weighted average number of shares.

• Basic EPS uses shares outstanding.
• Diluted EPS also counts shares that could be created from stock options, stock awards and convertible bonds. It is the more conservative figure and the one most investors quote.

EPS can grow even when the business does not, if the share count falls through buybacks (see dividends and buybacks). Always check whether EPS growth comes from higher profit or fewer shares.

GAAP and adjusted earnings

US companies report under GAAP (Generally Accepted Accounting Principles). Many also publish adjusted or non-GAAP earnings that exclude items such as stock-based compensation, restructuring charges or the amortisation of acquired intangible assets.

Adjusted numbers can help you see the underlying trend, but they are chosen by management. Two checks:

1. Look at the gap between GAAP EPS and adjusted EPS. A large and growing gap is a warning.
2. Watch for "one-time" charges that appear every year. If they recur, they are part of the cost of doing business.

EBITDA

EBITDA is earnings before interest, taxes, depreciation and amortisation. It is popular for comparing companies with different debt levels and in valuation ratios such as EV/EBITDA (see P/E ratio and valuation ratios). But it ignores the cost of replacing machinery and buildings, so for capital-heavy businesses it flatters profit. Cash flow, in free cash flow and the balance sheet, is the better check.

A five-minute routine for any company

1. Revenue growth year over year for the last four quarters and three years.
2. Gross and operating margin: rising, stable or falling?
3. Net income and diluted EPS: is growth from profit or from buybacks?
4. The gap between GAAP and adjusted EPS.
5. One competitor's margins for comparison.

Next: turning profit into a price tag with the P/E ratio and other valuation ratios.