Basic, lesson 1 of 4
The income statement in depth
What each line on the income statement means, when revenue and expense are recorded, and how bankers clean it up before they use it.
9 min, 3 checks
1Revenue and when it counts
Revenue is what the company charged customers for goods or services it delivered in the period. The key word is delivered. Under accrual accounting, a software company that sells a one-year subscription in January records one twelfth of it each month, not the whole thing on day one.
This rule, recognizing revenue when it is earned, explains most of the gaps between revenue and cash you will meet later. Cash collected early becomes deferred revenue. Revenue earned but not yet collected becomes accounts receivable.
2The cost lines
| Line | What goes in it | Example |
|---|---|---|
| Cost of goods sold | Direct costs of what was sold | Materials, factory labor, hosting for a software product |
| SG&A | Running the company | Sales salaries, marketing, rent, executive pay |
| R&D | Developing future products | Engineers building next year's product |
| D&A | Spreading the cost of long-lived assets | Depreciation of machines, amortization of acquired patents |
| Interest expense | Cost of debt | Interest on loans and bonds |
| Income tax | Taxes on pre-tax income | Federal and state income taxes |
Expenses follow the matching principle: a cost is recorded in the same period as the revenue it helped produce. That is why a $1 million machine is not expensed when it is bought. Its cost is spread across the years it is used, as depreciation.
Check 1
A company buys a $500,000 delivery truck that will last five years. What hits the income statement in the year of purchase, using straight-line depreciation and no salvage value?
3Earnings per share
Net income belongs to all shareholders together. Divide it by the number of shares and you get earnings per share, the figure most quoted in earnings headlines and in the price-to-earnings multiple.
EPS = Net income / Shares outstanding
Diluted EPS uses a share count that includes options and convertible securities that could become shares.
Check 2
Net income is $200 million and there are 80 million shares. What is EPS?
4Cleaning it up: non-recurring items
Reported income often includes items that will not happen again: a lawsuit settlement, a restructuring charge, a gain on selling a building. Bankers strip these out to get adjusted EBITDA or adjusted EPS, a better guide to what the business earns in a normal year.
Worked example
Adjusting EBITDA for a one-time charge
- 1Reported EBITDA: 180
- 2Included a one-time restructuring charge of 20
- 3Add it back: 180 + 20
Adjusted EBITDA of 200. A buyer valuing the company on next year's earnings uses 200, not 180.
Check 3
Pre-tax income is $180 and income tax expense is $45. What is the effective tax rate, in percent?
Terms in this lesson: Income statement, Accrual accounting, Deferred revenue, Accounts receivable, Depreciation, Amortization, Net income, EBITDA.
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