The income statement covers a period of time. It starts with revenue and subtracts costs in layers, each layer answering a different question.
| Line | Maple Outfitters | What it tells you |
|---|---|---|
| Revenue | 1,000 | Total sales |
| Cost of goods sold (COGS) | (600) | Direct cost of what was sold |
| Gross profit | 400 | Pricing power and production efficiency |
| Selling, general and administrative (SG&A) | (220) | Overhead and sales effort |
| Depreciation and amortization (D&A) | (50) | Wear on long-lived assets |
| Operating income (EBIT) | 130 | Profit from the core business |
| Interest expense | (20) | Cost of debt |
| Pre-tax income (EBT) | 110 | Profit before tax |
| Income tax at 25% | (27.5) | Tax on the year's profit |
| Net income | 82.5 | Profit to shareholders |
Gross margin = 400 / 1,000 = 40%. Operating margin = 130 / 1,000 = 13%. Net margin = 82.5 / 1,000 = 8.25%. Margins make companies of different sizes comparable.
Earnings before interest, taxes, depreciation and amortization = EBIT + D&A = 130 + 50 = 180. EBITDA is popular because it ignores capital structure and non-cash charges, but it is not cash flow: it ignores capital spending, working capital, interest and taxes. A business that must replace its equipment every five years has real costs that EBITDA hides.
Basic EPS = (net income minus preferred dividends) / weighted average common shares = 82.5 / 100 = $0.825. Diluted EPS assumes in-the-money options, restricted share units and convertible securities become shares, so it is equal to or lower than basic EPS. Always value a company on diluted figures.
Restructuring charges, impairments, gains on asset sales, litigation settlements and discontinued operations distort a single year. Analysts adjust for them to estimate normalized earnings. Be sceptical when a company reports restructuring charges every year: recurring 'one-time' costs are ordinary costs.
Companies publish adjusted earnings that exclude items management considers unusual, often including stock-based compensation. Regulators require a reconciliation to the nearest official measure. Read the reconciliation and decide for yourself whether each adjustment is fair. Stock-based compensation is a real cost paid in shares.
Some gains and losses skip net income and go to OCI: foreign currency translation of foreign subsidiaries, certain hedging results, and pension remeasurements. Net income plus OCI equals comprehensive income.
IFRS lets a company present operating expenses by function (cost of sales, selling, administration) or by nature (raw materials, employee costs, depreciation). Companies using the function format must disclose depreciation and employee costs in the notes. From 2027, IFRS 18 adds required subtotals (operating profit and profit before financing and income taxes) and requires companies to reconcile any 'management-defined performance measures' they publish, which will make adjusted figures easier to check.
Express each line as a percentage of revenue. Maple: COGS 60.0%, gross margin 40.0%, SG&A 22.0%, D&A 5.0%, EBIT margin 13.0%, interest 2.0%, tax 2.75%, net margin 8.25%. Three years side by side show which costs are growing faster than sales.
Fixed costs make profit swing more than revenue.
A company has revenue of 1,000, variable costs of 60% of revenue and fixed costs of 300.
| Line | Base | Revenue +10% |
|---|---|---|
| Revenue | 1,000 | 1,100 |
| Variable costs (60%) | (600) | (660) |
| Contribution | 400 | 440 |
| Fixed costs | (300) | (300) |
| EBIT | 100 | 140 |
A 10% rise in revenue lifted EBIT by 40%. The degree of operating leverage is contribution / EBIT = 400 / 100 = 4. The same arithmetic works in reverse: a 10% fall in revenue would cut EBIT by 40%, to 60.
EPS divides by the average number of shares outstanding during the period, weighted by time. A company with 100 million shares on January 1 that issues 20 million on July 1 has a weighted average of 100 + 20 x 0.5 = 110 million for the year.
Maple has 10 million employee options with a strike of $20, and the average share price is $25. Under the treasury stock method the exercise proceeds of $200 million buy back 8 million shares, so dilution is 2 million shares. Diluted EPS = 82.5 / 102 = $0.809, against basic EPS of $0.825. Options with a strike above the share price are left out because they would raise EPS (they are anti-dilutive).
Companies with several businesses report revenue, profit and often assets by operating segment, as management sees them. Segment data shows which part of the company earns the profit. It is common for one division to produce most of the earnings while another absorbs capital.
The tax note reconciles the statutory rate with the effective rate: lower foreign tax rates, non-deductible expenses, tax credits and changes in deferred tax estimates. A falling effective rate that comes from one-time items will not repeat.
Prepare common-size income statements for your two companies for three years and compute each company's degree of operating leverage from one year to the next.
For one of your companies, build a three-year table of revenue, gross margin, operating margin and net margin. List every item in the non-GAAP reconciliation and mark whether you would accept the adjustment.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.