Financial Reports: How to Read the Income Statement for Profit and Loss Types
For readers of financial statements, bottom-line numbers don’t tell the entire story of how a company is doing. When you hear earnings or profits reports on the news, most of the time, the reporters are discussing the net profit, net income, or net loss. Relying solely on the bottom-line number is like reading the last few pages of a novel and thinking that you understand the entire story.
Because companies have so many different charges or expenses unique to their operations, different profit lines are used for different types of analysis. For example, gross profit is the best number to use to analyze how well a company is managing its sales and the costs of producing those sales, but gross profit gives you no idea how well the company is managing the rest of its expenses.
Using operating profits, which show you how much money a company made after considering all costs and expenses for operating, you can analyze how efficiently the company is managing its operating activities, but you don’t get enough detail to analyze product costs.
A commonly used measure to compare companies is earnings before interest, taxes, depreciation, and amortization, also known as EBITDA. With this number, analysts and investors can compare profitability among companies or industries because it eliminates the effects of the companies’ activities to raise cash outside their operating activities. EBITDA also eliminates any accounting decisions that may impact the bottom line, such as the companies’ policies relating to depreciation methods.
Investors reading the financial report can use this line item to focus on the profitability of each company’s operations. If a company does include this line item, it appears at the bottom of the expenses section but before line items listing interest, taxes, depreciation, and amortization.
How a firm chooses to raise money can greatly impact its bottom line. Selling equity has no annual costs if dividends aren’t paid. Borrowing money means interest costs must be paid every year, so a company will have ongoing required expenses.
EBITDA gives financial report readers a view of how well a company is doing without considering its financial and accounting decisions. This number became popular in the 1980s, when leveraged buyouts were common. A leveraged buyout takes place when an individual or company buys a controlling interest in a company, primarily using debt. This fad left businesses in danger of not earning enough from operations to pay their debt load.
Today EBITDA is frequently touted by technology companies or other high-growth companies with large expenses for machinery and other equipment. In these situations, the companies like to discuss their earnings before the huge write-offs for depreciation, which can make the bottom line look pretty small.
Be aware that a company can use EBITDA as an accounting gimmick to make earnings sound better to the general public or to investors who don’t take the time to read the fine print in the annual report.
Firms can get pretty creative when it comes to their income statement groupings. If you don’t understand a line item, be sure to look for explanations in the notes to the financial statements. If you can’t find an explanation there, call investor relations and ask questions.
Nonoperating income or expense
If a company earns income from a source that isn’t part of its normal revenue-generating activities, it usually lists this income on the income statement as nonoperating income. Items commonly listed here include the sale of a building, manufacturing facility, or company division. Other types of nonoperating income include interest from notes receivable and marketable securities, dividends from investments in other companies’ stock, and rent revenue.
Companies also group one-time expenses in the nonoperating section of the income statement. For example, the severance and other costs of closing a division or factory appear in this area, or, in some cases, the statement has a separate section on discontinuing operations. Other types of expenses include casualty losses from theft, vandalism, or fire; loss from the sale or abandonment of property, plant, or equipment; and loss from strikes.
You usually find explanations for income or expenses from nonoperating activities in the notes to the financial statements. Companies need to separate these nonoperating activities; otherwise, investors, analysts, and other interested parties can’t gauge how well a company is doing with its core operating activities.
The Core operating activities line item is where you find a company’s continuing income. If those core activities aren’t raising enough income, the firm may be on the road to significant financial difficulties.
A major gain may make the bottom line look great, but it can send the wrong signal, who may then expect similar earnings results the next year. If the company doesn’t repeat the results the following year, Wall Street will surely hammer its stock. A major one-time loss also needs special explanation so that Wall Street doesn’t downgrade the stock unnecessarily if the one-time nonoperating loss won’t be repeated.
Whether a gain or a loss, separating nonoperating income from operating income and expenses helps avoid sending the wrong signal to analysts and investors about a company’s future earnings and growth potential.
Net profit or loss
The bottom line of any income statement is net profit or loss. This number means little if you don’t understand the other line items that make up the income statement. Few investors and analysts look solely at net profit or loss to make a major decision about whether a company is a good investment.