The Income Statement

The cascading logic of the income statement

The income statement (profit and loss account) describes a company's performance over a period (quarter, half-year, year). It is structured as a cascade: starting from revenue, successive categories of expenses are deducted, producing intermediate profit levels that each tell you something different about the business.

1. Revenue (turnover)Amounts earned from selling goods and services, recognized when the obligation to the customer is fulfilled, not necessarily when the cash is received.
2. Gross profitRevenue minus cost of sales; it reflects production efficiency and pricing power.
3. Operating profit (EBIT)Gross profit minus distribution, administrative and other operating expenses, including depreciation and amortization.
4. Profit before taxEBIT plus finance income minus finance costs (mainly interest).
5. Net profitProfit before tax minus income tax; this is the result attributable to shareholders.

Each step of the cascade isolates a different type of decision. Gross profit mainly reflects production and pricing policy, operating profit adds the efficiency of the overhead cost structure, and net profit includes the effect of financing decisions and taxation. That is why an analyst does not stop at the bottom line: two companies with the same net profit may have very different operating businesses, offset by different financing structures. Comparing all the intermediate levels over several years shows where value is created and where it is lost.

Margins and EBITDA

Margins let you compare companies of different sizes and track changes over time. A falling gross margin may signal pricing pressure or rising raw material costs; a falling net margin with a stable operating margin may point to a higher cost of debt.

A complete example and earnings per share

Earnings quality

Not all profit is equally valuable to an investor. Recurring profit from the core business is more relevant for valuation than non-recurring gains, such as the sale of land or the reversal of a provision.

• Separate exceptional items from the result of the core business.
• Compare revenue growth with growth in receivables: if receivables grow much faster, the quality of revenue may be questionable.
• Track margins over at least three to five years, not just in a single financial year.
• Compare net profit with cash flow from operating activities.

Also check whether the number of shares changed during the period through new issues or buybacks. EPS growth achieved only by reducing the share count does not mean the same thing as growth in net profit generated by the core business.