How to Read a Financial Report. John A. Tracy

much. Also, people are interested in the size of the business, which usually refers to the annual sales revenue. The income statement summarizes sales revenue and expenses for a period of time (one year in Exhibit 2.1). All the dollar amounts reported in this financial statement are cumulative totals for the whole period.

      The top line identifies the total amount of proceeds or gross income from sales to customers, and is generally called sales revenue. The bottom line reflects net income (also sometimes called net earnings, but seldom profit or net profit). Net income is the final profit after all expenses are deducted from sales revenue. The business in this example earned $2,642,000 net income on its sales revenue of $52,000,000 for the year. In other words, after deducting all expenses, only a smidgeon more than 5 percent of the company’s sales revenue remained as final profit (net income).

      The income statement is read in a step-down manner, like walking down stairs. Each step down is a deduction of one or more expenses. The first step deducts the cost of goods (products) sold from the sales revenue of goods sold, which gives gross margin. (Note that gross margin is also called gross profit, which is one of the few terms on an income statement that contains the word profit.) This measure of profit is called gross because many other expenses have not yet been deducted.

      Next, two additional expense deductions are made. The first is selling, general, and administrative expenses, which is a broad category of operating expenses. The second is the depreciation expense (a unique expense). Both of these are deducted from gross margin, giving earnings before interest and income tax. This measure of profit is also called operating earnings (which sometimes goes by a slightly different name). Next, interest expense on debt is deducted, which gives earnings before income tax. The last step is to deduct income tax expense, which gives net income, which appears on the bottom line on the income statement. Undoubtedly, you’ve heard the term “bottom line,” and the placement of net income on the income statement is where it comes from. (However, this slang is not used in financial reports.)

      As an aside, note that you may hear the income statement called a profit and loss or P&L statement. This title is not used in external financial reports released outside the business.

Exhibit 2.1 depicts a multiple-step income statement, which shows three intermediate measures of profit. Exhibit 2.3 depicts a single-step income statement. The single-step format reports only the final line of net income instead of calculating it various times along the way.

EXHIBIT 2.3 SINGLE-STEP INCOME STATEMENT

Dollar Amounts in Thousands
Sales Revenue	$ 52,000)
Cost of Goods Sold Expense	$ (33,800)
Selling, General, and Administrative Expenses	$ (12,480)
Depreciation Expense	$ (785)
Interest Expense	$ (545)
Income Tax Expense	$ (1,748)
Net Income	$ 2,642)

Publicly owned business corporations are required to report earnings per share (EPS), which is basically the annual net income divided by the number of capital stock shares. Privately owned businesses don’t have to report EPS, but this figure may be useful to their stockholders. We explain earnings per share in Chapter 13.

      In our income statement example (Exhibit 2.1) you see five different expenses. You may find more expense lines in an income statement, but there would seldom be more than 10 or so, as a general rule. (There can be exceptions if a business has a very unusual year.) One expense that companies are required to report is cost of goods sold. Depreciation, another expense, is so unique that we prefer to report it on a separate line, but some companies do not do this. However, depreciation can be included in another operating expense in the income statement instead of being reported separately.

      Other than depreciation, Exhibit 2.1 includes just one broad, all-inclusive operating expenses line, “Selling, General, and Administrative Expenses.” A business has the option of disclosing two or more operating expenses, and many do. Marketing, promotional, and selling expenses often are separated from general and administration expenses. The level of detail for expenses in income statements is flexible; financial reporting standards are somewhat loose on this point.

      The sales revenue and expenses reported in income statements follow generally accepted conventions, which we briefly summarize here:

       Sales revenue: The total amount received or to be received from the sales of products (and/or services) to customers during the period. Sales revenue is net, which means that discounts off list prices, prompt payment discounts, sales returns, and any other deductions from original sales prices are deducted to determine the sales revenue amount for the period. Sales taxes are not included in sales revenue, nor are excise taxes that might apply. In short, sales revenue is the amount the business should receive to cover its expenses and to provide profit (bottom-line net income).

       Cost of goods sold expense: The total cost of goods (products) sold to customers during the period. This is clear enough. What might not be so clear, however, is the expense of goods that were shoplifted or are otherwise missing, and write-downs due to damage and obsolescence. The cost of such inventory shrinkage may be included in cost of goods sold expense for the year (or, this cost may be put in another expense account instead).

       Selling, general, and administrative expenses (operating expenses): Broadly speaking, every expense other than cost of goods sold, interest, and income tax. This broad category is a catchall for every expense not reported separately. In our example, depreciation is broken out as a separate expense instead of being included with other operating expenses. Some companies report advertising and marketing costs separately from administrative and general costs, and some report research and development expenses separately. There are hundreds, even thousands, of specific operating expenses, some rather large and some very small. They range from salaries and wages of employees (large) to legal fees (small, one hopes).

       Depreciation expense: The portions of original costs of long-term assets including buildings, machinery, equipment, tools, furniture, computers, and vehicles that is recorded to expense in one period. Depreciation is the “charge” for using these so-called fixed assets during the period. This expense amount is not a cash outlay in the period recorded, which makes it a unique expense compared with other operating expenses.

       Interest expense: The amount of interest on debt (interest-bearing liabilities) for the period. Other types of financing charges may also be included, such as loan origination fees.

       Income tax expense: The total amount due to the government (both federal and state) on the amount of taxable income of the business during the period. Taxable income is multiplied by the appropriate tax rates. The income tax expense does not include other types of taxes, such as unemployment and Social Security taxes on the company’s payroll. These other, non-income taxes are included in operating expenses.

      A business may present a two- or three-year comparative income