Income Statement of a Company (Profit and Loss)

The income statement, also known as the profit and loss statement, is one of the main financial reports used to assess a company's financial health. This document presents the revenues, costs, and expenses over a specific period, revealing the organization's profitability.

1. Structure of the Income Statement (P&L)

The income statement follows a hierarchical structure that breaks down step by step how revenues are generated and used. Below are the main components:

1.1 Revenue (Also known as the TOP Line, as it appears at the top)

Revenue represents the total sales or services provided by a company during a period. These can be divided into:

• Operating revenue: Derived from the company's primary business activity.

• Non-operating revenue: Derived from secondary activities, such as investments.

1.2 Cost of Goods Sold (COGS)

Includes all direct expenses associated with the production or acquisition of the goods sold or services provided, i.e., the cost of manufacturing the product or providing the service. Example: raw materials, direct labor.

1.3 Gross Profit

Gross profit is calculated by subtracting COGS from revenue. This indicator measures the basic profitability of operations before considering other expenses.

1.4 Operating Expenses (OPEX)

Includes all costs necessary to run the business, excluding COGS. These include:

o Research and Development (R&D): Investments in innovation.

o Selling, General & Administrative (SG&A): Salaries, rent, utilities, marketing.

1.5 Operating Profit (EBIT - Earnings Before Interest and Taxes)

EBIT is calculated by subtracting operating expenses from gross profit. It represents the profit generated by the main operation before considering interest and taxes.

1.6 Interest and Taxes

Interest: Payments related to financial debt.
Taxes: Tax obligations derived from profits.

1.7 Depreciation and Amortization

Depreciation: Reduction in the value of tangible assets due to wear or use (machinery, vehicles, real estate).
Amortization: Reduction in the value of intangible assets (patents).

1.8 EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

EBITDA eliminates the impact of interest, taxes, depreciation, and amortization, providing a clear view of operational cash generation.

1.9 Net Profit (Also known as the BOTTOM Line, as it appears at the bottom)

This is the final line of the income statement and reflects the final profit after deducting all costs, expenses, interest, and taxes.

EPS (Earnings Per Share): Calculated as net profit divided by outstanding shares, indicating how much net profit corresponds to each share.
Share dilution: Increase in the number of outstanding shares, which reduces the value of earnings per share (EPS).

2. Types of Margins

Financial margins are key profitability indicators. Some of the most common ones are:

· Gross Margin: Gross Profit / Revenue. (Good margin => 40%)

· Net Margin: Net Profit / Revenue. (Good margin => 20%)

Margins depend heavily on the type of company. For example, if it is a technology company, margins are typically higher than those of an industrial or retail business. It is important, when comparing margins between companies, to do so within the same industry or sector.

Generally, having high margins tends to attract competition. This means competitors may emerge seeking to capture part of those margins, potentially leading to price wars, quality battles, or innovation races.

Having very low margins and finding the company in a downturn of its economic cycle could be an excellent entry point to buy shares, especially if we foresee a potential catalyst for a change in the cycle. In companies with narrow margins, a small increase in sales can result in a significant boost in profits and, consequently, in the stock's return, thanks to operational leverage.

3. Difference Between Costs and Expenses

📌Costs: Directly related to the production or acquisition of goods or services (COGS). Common examples include: raw materials used in product manufacturing, salaries of employees directly involved in production, machinery and tools used in manufacturing, transportation for goods distribution, and specific services contracted for product creation.

📌Expenses: Associated with the general operation of the business (SG&A, R&D). This includes: marketing, personnel, rent, leasing, computers, insurance, utilities (water, electricity, internet), office supplies, transportation, staff training, and external consulting services.

4. Operating Leverage

Operating leverage measures how fixed costs impact operating profit. Companies with high fixed costs have high operating leverage, which can increase profits with small revenue increments but also raises risk during periods of low sales.

Example of High Operating Leverage: An airline, with high fixed costs such as airplanes, fuel, and permanent staff. If demand for flights increases, most of the additional revenue translates into profit, but during periods of low demand, losses can be significant.
Example of Low Operating Leverage: An independent consulting firm, where costs are mostly variable (payment to consultants per project). If demand decreases, costs also drop proportionally, reducing financial risk.

5. Differences Between EBIT and EBITDA

📌EBIT: Excludes interest and taxes but includes depreciation and amortization.

📌EBITDA: Excludes interest, taxes, depreciation, and amortization, providing a more focused view of operational capacity.

Example:

· Revenue:$100,000

· COGS: $40,000

· OPEX: $20,000

· Depreciation: $5,000

Calculations:

· EBIT = ($100,000 - $40,000 - $20,000) = $40,000

· EBITDA = EBIT + Depreciation = $40,000 + $5,000 = $45,000

6. Difference Between CAPEX and OPEX

📌CAPEX (Capital Expenditures): Investments in fixed assets (machinery, buildings). For example, purchasing a new production line for a factory, acquiring land to build offices, or buying technological equipment like servers for a tech company.

📌OPEX (Operating Expenditures): Recurring expenses to operate the business. Examples of OPEX include administrative staff salaries, office rental costs, marketing and advertising expenses, utility payments such as electricity and water, equipment maintenance, software licenses, and insurance costs. For instance, a tech company might include in its OPEX the costs of cloud management tools subscriptions and system maintenance.

7. Green Flags in the Income Statement

✅Revenue growth acceleration.

✅Gross margin expansion. Revenue increases without a corresponding rise in COGS, meaning product sales prices are rising without affecting total sales.

✅Operating margin expansion. Operating expenses grow at a slower rate than revenue (more revenue with relatively lower expenses, indicating improved efficiency and cost-conscious policies).

✅Interest income exceeds interest expenses.

✅Reasonable tax rate.

8. Yellow Flags in the Income Statement

🟡Sudden halt in revenue growth. This can be especially problematic for companies with high customer concentration. For example, a manufacturing company that relies on 70% of its revenue from a single client may face a crisis if that client switches suppliers or significantly reduces orders.

🟡Increase in marketing expenses without a proportional sales boost. A clear example occurs during high inflation: a food company may significantly increase its advertising expenses to maintain market position, but rising product prices (falling gross margins due to raw material costs) may drive consumers to cheaper alternatives. This loss of competitiveness affects sales, creating a mismatch between marketing costs and generated revenue.

9. Difference Between Amortization, Depreciation, and Impairment

📌Depreciation: Reduction in the value of tangible assets due to use, wear, or aging. Examples: industrial machinery losing value over years of continuous use, vehicles depreciating due to mileage and wear, and buildings losing value over time due to weather conditions and aging. Depreciation is reflected in financial reports over the asset’s useful life.

📌Amortization: Reduction in the value of intangible assets over time or due to use. Examples: patents nearing expiration, software licenses with defined usage periods, copyrights, and goodwill associated with acquisitions. Amortization helps account for the gradual decrease in the value of these assets in financial statements.

📌Impairment: Reduction in the recoverable value of an asset when its book value exceeds the estimated recoverable amount. Examples: a production plant becoming obsolete due to technological advances or a patent losing utility before its expiration date. Impairment is recorded as an expense in the income statement and may signal strategic or asset management issues.

10. Depreciation Methods

📌Straight-line: Equal amount each period.

Example: A company purchases industrial equipment for $50,000, with an estimated useful life of 10 years and a residual value of $5,000.

- - - Using the straight-line method, annual depreciation is $4,500, calculated as (50,000−5,000)/10.

📌Declining Balance: Higher depreciation at the start.

Example: A company buys a vehicle for $30,000 with an estimated 5-year lifespan and applies a 20% annual depreciation rate.

o Year 1: Depreciation = $6,000 (20% of $30,000).

o Year 2: Depreciation = $4,800 (20% of the remaining $24,000).

📌Sum-of-the-Years Digits: Accelerated depreciation.

Example: A machine is purchased for $50,000 with a 5-year life. The depreciation is calculated by summing the digits of the years (5+4+3+2+1=15).

Year 1: Depreciation = 5/15×50,000= 16,666.67.

Year 2: Depreciation = 4/15×50,000=13,333.33.

📌MACRS: Used for tax purposes in the U.S.

Example: A company buys machinery classifies it as a 5-year asset under MACRS.

o Year 1: 20% depreciation.

o Subsequent years follow the MACRS depreciation schedule, decreasing annually.

📌Service Hour: Based on usage.

Example: A company operates a generator worth $120,000 with an estimated lifespan of 10,000 hours. Depreciation cost per hour is $12 (120,000/10,000)

o If the generator operates 1,500 hours in a year, depreciation is 1,500×12=18,000$.

o This method accurately reflects asset wear based on actual use.

11. Deferred Revenue

Deferred revenue, also known as unearned revenue, refers to payments received by a company for goods or services that have not yet been delivered or performed. It represents a liability on the balance sheet because the company is obligated to deliver the product or service in the future.

Key Characteristics:

Liability Account: Recorded as a current or non-current liability, depending on when the obligation will be fulfilled.
Common Examples: Subscription services, prepaid rent, or annual maintenance contracts.
Revenue Recognition: Deferred revenue is recognized as earned revenue on the income statement when the goods or services are delivered.