By Peet Serfontein
Analysing income statements
An income statement, also known as a profit and loss statement, is a vital financial document that details a company's revenues, expenses, and profits over a specific period-typically quarterly, semi-annually, or annually. This report gives businesses, investors, and stakeholders the information to understand how efficiently a company is managing its operations and if it is generating a profit.
Knowing how to analyse an income statement is essential for understanding a company's financial performance. The key components-revenue, cost of sales, gross profit, operating expenses, operating profit, finance costs, pre-tax income, income tax expense, and net income-each provide valuable insights into different aspects of a company's financial health.
Revenue (or sales or turnover)
Revenue, often called the "top line" of the income statement, is the total income generated from a company's core business operations before any expenses are deducted. It reflects the company's ability to generate sales from its products or services and is the starting point of the income statement. Revenue is critical because it provides a first look at the size and growth of a business.
Cost of Goods Sold (or cost of sales)
Cost of Goods Sold (COGS) refers to the direct costs incurred by a company to produce the goods or services it sells. COGS typically includes the cost of raw materials or inventory, labour directly involved in production, and manufacturing overhead costs. In service-based businesses, COGS may include labour and other direct costs of providing the service.
For instance, in a manufacturing company that produces furniture, COGS would include the cost of wood, nails, paint, and labour used to create the furniture. If this company incurs R800,000 in costs to produce its products, that amount will be recorded as COGS. COGS is crucial because it helps determine gross profit, which is calculated as revenue minus COGS. Gross profit shows how much money the company retains after covering the direct costs of production. A company can improve its gross profit by effectively managing COGS, which is vital for sustaining profitability.
COGS is crucial because it helps determine gross profit, which is calculated as revenue minus COGS. Gross profit shows how much money the company retains after covering the direct costs of production. A company can improve its gross profit by effectively managing COGS, which is vital for sustaining profitability
Gross profit
Gross profit is the amount remaining after subtracting the COGS from revenue. It is an essential measure of profitability that reflects how efficiently a company can produce and sell its goods or services. A high gross profit relative to sales indicates that the company is effectively managing its production costs, while a low gross profit relative to sales may suggest inefficiencies or pricing issues.
By way of an example, if a South African manufacturing company has total revenue of R2 million and COGS of R800,000, its gross profit would be R1.2 million. Gross profit can then be expressed as a percentage of sales, known as the gross profit margin. The gross profit margin is calculated as (Gross Profit ÷ Revenue) * 100. In our example, the gross profit margin would be 60%, meaning the company retains 60% of its sales revenue after covering direct production costs. You can then either compare this metric to competitors or relative to the company's history to see how well a company is managing its production costs and whether it is pricing its products or services appropriately. A higher gross profit margin typically indicates better cost management or pricing strategies.
Operating expenses (or operating costs)
Operating expenses represent the costs a company incurs to run its day-to-day business activities that are not directly related to the production of goods or services. These expenses include administrative costs, salaries for non-production staff, marketing expenses, research and development (R&D), rent, and utilities.
In total, the company's operating expenses would amount to R550,000. These costs are subtracted from the gross profit to calculate operating income or operating profit. Effectively managing operating expenses is crucial for a company's long-term profitability. A company with high operating expenses relative to its revenue may struggle to achieve consistent profits, even if its gross profit is substantial.
Effectively managing operating expenses is crucial for a company's long-term profitability. A company with high operating expenses relative to its revenue may struggle to achieve consistent profits, even if its gross profit is substantial.
Operating income (operating profit or Earnings before Interest and Tax [EBIT])
Operating income is the profit a company earns from its core business activities before deducting interest expenses and taxes. Operating income is a critical measure of a company's operational efficiency because it excludes the effects of financing and tax strategies, focusing solely on how well the company's operations are performing.
To calculate operating income, operating expenses are subtracted from gross profit. In our example, the operating income would be R1.2 million - R550,000 = R650,000. This figure provides insight into how much profit the company generates from its core activities before financing costs and taxes are considered. Operating income is important because it helps investors and managers assess the profitability of a company's operations without the influence of non-operating factors. It is a key indicator of the company's ability to generate profit from its primary activities.
Operating income is important because it helps investors and managers assess the profitability of a company's operations without the influence of non-operating factors. It is a key indicator of the company's ability to generate profit from its primary activities.
Operating profit can also be expressed as a percentage of revenue—the operating margin can then be compared to other players in the industry and the company's own history to see how efficiently the company is being run on a relative basis.
Other Income and Expenses
In addition to revenue from core operations, companies may earn income or incur expenses from non-operational activities. These items are categorized as other income and expenses and are included after operating income in the income statement. Common examples include:
For instance, a company may earn R20,000 in interest income from its investments while paying R15,000 in interest expenses on its loans. These figures would be recorded in the other income and expenses section, resulting in a net other income of R5,000. Other income and expenses are important because they reflect non-operational activities that can impact a company's bottom line, although they are not directly related to the company's core business operations.
Pre-tax Income (or Profit Before Tax [PBT] or Earnings Before Tax [EBT])
Pre-tax income is the amount of profit a company earns before accounting for taxes. It is calculated by adding or subtracting other income and expenses from operating income. Pre-tax income provides insight into how profitable a company is before the effects of tax policies, which can vary by country and region.
Our company has an operating income of R650,000 and net other income of R5,000, translating to pre-tax income of R655,000. Pre-tax income is significant because it allows for comparison across companies, sectors, and geographies, regardless of varying tax rates or regulations.
Income Tax Expense
The tax a company is required to pay based on its pre-tax income. In South Africa, corporate tax rates currently sit at 27%, although the rate can vary depending on specific conditions, tax credits, or government incentives. The tax expense is calculated by applying the tax rate to the pre-tax income.
For example, if our manufacturer has a pre-tax income of R655,000 and the corporate tax rate is 27%, the company will owe R655,000 * 0.27 = R176,850 in taxes to SARS. This tax expense is subtracted from pre-tax income to calculate net income.
Net Income (or Net Profit)
Net income, often referred to as the “bottom line” of the income statement, is the final profit a company earns after all expenses, including taxes, have been deducted from revenue. Net income is a crucial figure for investors and stakeholders because it represents the amount of profit available to be reinvested in the business, paid out as dividends to shareholders, or retained as earnings.
In our example, the company has delivered a net income of R655 000 - R176 850 = R478 150.
Net income is the ultimate indicator of a company's profitability. It shows how effectively the company is managing both its operations and its financial obligations. A growing net income over time typically indicates a healthy, profitable company, while a declining net income may signal financial difficulties.
Below is an example of an income statement for our hypothetical manufacturing company, XYZ Ltd.
