How to read an income statement
The income statement (P&L) line by line: revenue, cost of goods sold, gross profit, operating expenses, operating income and net income.
Top line to bottom line
The income statement covers a period of time, a quarter or a year. It starts with revenue and subtracts costs in layers, and each layer shows a different kind of profit, until only net income is left at the bottom.
| Revenue | 10,000 |
| Cost of goods sold | (6,000) |
| Gross profit | 4,000 |
| Sales, general & admin | (1,500) |
| Research & development | (1,000) |
| Operating income | 1,500 |
| Interest expense | (300) |
| Income tax | (250) |
| Net income | 950 |
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Revenue sits on the first line and net income on the last, which is where the everyday phrases “top line” and “bottom line” come from. A company that “grew the top line” sold more; one whose bottom line suffered earned less profit.
Public companies show several years side by side so you can see the trend without hunting for old reports. The SEC requires three years of income statements in the annual report (two for smaller companies).
Two kinds of cost
Cost of goods sold (COGS) is the direct cost of making what was sold: parts, factory labor, freight. Operating expenses (OpEx) are everything else it takes to run the company, such as sales and marketing, admin, and research & development.
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The split matters because the two behave differently. COGS rises with every unit sold. Many operating expenses, like headquarters rent or the finance team, stay roughly the same whether sales double or halve. Costs that move with volume are called variable costs; costs that don’t are fixed costs.
Where a cost goes is sometimes a judgment call. A software company’s server bills usually sit in cost of revenue (the services version of COGS), while the engineers building new features sit in R&D, an operating expense.
Operating income
Operating income is what the core business earns before interest and taxes, which is why it’s often called EBIT. Because it ignores how a company is financed, it compares a debt-heavy company with a debt-free one fairly.
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EBIT stands for earnings before interest and taxes. Below it come interest expense (the cost of debt) and income tax, and then net income. Two companies running identical businesses can end with very different net income just because one borrowed heavily.
That’s why analysts track operating income over the years to judge whether the business itself is improving. Tax rates and interest costs can change for reasons that have nothing to do with how well the company sells.
Key terms
- Income statement
- Revenue and costs over a period, ending in net income. Also called the P&L.
- COGS
- Cost of goods sold: the direct cost of making what was sold.
- Operating income
- Profit from the core business before interest and tax. Often close to “EBIT”.
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