Dissecting the Income Statement: A Beginner Guide
By Max Grinold
The Income Statement provides valuable information about the financial health of a company over a specified period in time. Many well-known public companies report their income statements in 10K (yearly) or 10Q (quarterly) filings. To further understand how the income statement is constructed, let's walk through a hypothetical case study of opening a skateboard business.
From Revenue to Gross Profit
Revenue: In this scenario let's say you sell 2000 skateboards over the year for $100 a piece. This would make your revenue, or sales, for the year $200,000.
COGS: Cost of goods sold (COGS) represents the direct costs of goods that are directly attributed to producing the goods that a company sells. For each skateboard, the board costs $25, the trucks cost $15, and the wheels cost $10. This would make the direct costs for the materials that go into each skateboard $50. If you sell 2000 skateboards in the year, that would make your COGS $100,000.
Gross Profit: Your gross profit for the year would be your revenue minus the cost of goods sold. So your $200,000 of sales minus the $100,000 COGS would give you a gross profit of $100,000. This would give you a gross margin (gross profit / revenue) of 50%. The gross margin of your company gives you valuable insight into the revenue retained from your sales when factoring in production costs. A higher gross margin means you have a higher percentage of revenue retained after factoring all of the direct costs related to producing the goods of your business.
From Gross Profit to EBITDA
Operating costs: Let’s say your skateboard business has 3 employees who are each paid $15,000 a year, a yearly lease on a storefront of $20,000, advertisements in the newspaper for $5,000 a year, and utility costs (electricity and water) of $5,000 a year. All of these costs, which are not related to the direct production of skateboards, are considered operating expenses. These can be thought of as costs related to running the business on a day-to-day basis. So factoring in your salaries of $15,000, rent of $20,000, marketing costs of $5,000, and utilities costs of $5,000, your total operating expenses for the year would be $45,000.
EBITDA: When subtracting your operating expenses of $45,000 from your gross profit of $100,000, you are left with $55,000 in earnings before interest, taxes, and depreciation (EBITDA). EBITDA represents the core profitability of your company before factoring in expenses that aren’t directly involved in operations as well as accounting adjustments.
EBITDA to EBIT
Depreciation: In order to make your skateboards, you buy a wood-cutting machine for $20,000 at the start of the year. These machines are expected to last 4 years before needing to be replaced. Depreciation is the accounting practice used to spread out the cost of this machine over its useful life. Since the machine is essential for producing your goods, depreciation helps allocate the expense of the machine evenly across the years it will be used, reflecting its gradual loss of value over time. This is because if you were to hypothetically sell your machine in year 3, it would not be as valuable as when you bought it since it only has 1 year of use left, so depreciating the asset represents the loss in value of the asset each year. Since your machine lasts 4 years, and you dont plan to sell it during its useful life, you use an accounting practice known as straight-line depreciation. To calculate your depreciation expense for the year you divide the original value of the machine ($20,000) by its expected life (4 years), giving you a depreciation expense during the year of $5,000.
EBIT: Factoring in your depreciation expense, your EBITDA minus the $5,000 in depreciation gives you earnings before interest and taxes of $50,000.
EBIT to Net Income
Interest: Let’s say that to kickstart your business, you take out a loan from the bank at the start of the year of $50,000 with a 5% annual interest rate. This means that each year you need to pay 5% in interest on your outstanding loan balance, which would be $2,500 this year. So subtracting this interest expense from your EBIT, you are left with $45,000.
Taxes: Even after all of the expenses involved in starting your business, you still can’t forget about your payment to Uncle Sam. So with a tax rate on your business of 40% you do the simple equation of $45,000 multiplied by 1 minus the tax rate of 40% and are left with a net income of $27,000. This represents the final income that you can take home after accounting for all of your expenses, debt obligations, and taxes.
