Greg McFarlane is an advertising copywriter who lives in Las Vegas and Lahaina. He recently wrote Control Your Cash: Making Money Make Sense, a financial primer for people in their 20s and 30s who know nothing about money. Buy the book here (physical) or here (Kindle) and reach Greg at Greg at ControlYourCash dot com.
Editor’s Note: This post contains Rish-rated images and may not be safe for work. As such content is somewhat unprecedented on this site, I just thought I’d warn you!
Last month Control Your Cash did a post on financial statements and how to read them. But no matter how hard we gussied them up, put tight little clothes on them and smothered them in lipstick, people still had a tough time paying attention. So to retain your interest this time, every few paragraphs we’ll intersperse soft-core pictures along with the meat of this post about the first of the three fundamental financial statements: the income statement.
An income statement (or as accountants call it, a profit & loss statement or simply a P&L) shows how a company’s revenue turns into its net income over a given period, usually a year. Income (or profit) is what we’re curious about here, rather than mere revenue. Sure, you can sell $1 trillion worth of office supplies or routers, but if you’re spending $1.1 billion to accomplish that, then, your company probably isn’t that going to be great of an investment. A profitable company has to spend as little as possible to sell as much as possible.
Here’s an example of a healthy income statement: it’s the latest annual one from one of America’s most profitable companies, Microsoft.
This is an overly simplistic income statement, which is fine for starters. To determine profit, the statement tallies revenue and subtracts expenses. That works for any entity – you, your neighbor, your own business, or a multinational company that makes ubiquitous and occasionally erratic operating systems.
Here you go, ladies. I believe his name is Sergio:
And we’re back.
The REVENUE figure above is everything Microsoft sold from July 1, 2008 through June 30, 2009. Every copy of Vista, every Xbox Live membership, every Zune. Add it all up and it totals $62,484,000,000, give or take $500,000.
Then, we subtract everything Microsoft had to spend to sell all that. That’s called OPERATING EXPENSES, and in this simplified income statement, Microsoft separates it into 5 categories:
COST OF REVENUE. Most companies buy raw materials and turn them into something fancier. That’s the very definition of wealth – turning assets from lower-valued to higher-valued uses. Sometimes this item is listed on the income statement as “Cost of Sales” or something similar. Either way, we see that it represents less than one-fifth of Microsoft’s revenue. That’s because most of what makes Microsoft wealthy is…what? Code. Billions of lines of code, devised by humans, rather than made from shipments of iron ore or containers full of soybeans. For a similarly profitable company with a more quotidian business, such as Walmart, cost of revenue can eat up as much as ¾ of revenue.
RESEARCH AND DEVELOPMENT is pretty straightforward, and obviously a big part of Microsoft’s business.
SALES AND MARKETING is even larger than COST OF REVENUE, which is fairly unusual for a company of Microsoft’s size. But again, that illustrates how much of Microsoft’s revenue derives from the brainpower of its employees. And if you check the dates, you’ll realize that the $13,214,000,000 Microsoft spent on sales and marketing includes those embarrassing Jerry Seinfeld/Bill Gates commercials.
GENERAL AND ADMINISTRATIVE is what it sounds like. Airfare for traveling executives, payments to the janitorial company, utility bills, etc.
EMPLOYEE SEVERANCE is relatively small, but big enough that the company devoted an entire subcategory to it. We’re not sure how many employees that covered, nor is it all that important relative to the other numbers on the income statement.
Still with us? Here’s one for the guys. Not sure if this is a bathing suit or underwear, like it matters:
Subtract expenses from revenue, that’s your OPERATING INCOME.
A little cleansing, folding and manipulating and we’re almost at the critical number, NET INCOME. Really, to get there we just subtract taxes and add OTHER INCOME, which is only 3% of OPERATING INCOME. OTHER INCOME includes things like selling used company cars, and additional stuff that has nothing to do with the company’s core business.
So there you have it. Microsoft’s NET INCOME wasn’t just enormous, it was up 29% over the previous year.
The remaining columns just concern how many outstanding shares of Microsoft stock there are. “Diluted” means you’re recalculating the numbers assuming that everyone who owned Microsoft stock options had actually exercised them and bought stock.
As long as a company turns a profit, isn’t NET INCOME going to be large if REVENUE is large?
Glad you pointed that out. One is indeed a function of the other, but as we said, taking in a lot of money doesn’t necessarily mean making a lot.
Boy, it’d sure be swell if there was a way of comparing NET INCOME among companies with similar REVENUE numbers. Hey…what if we were to divide the one into the other?
Now you’re talking. That’s called profit margin, and it’s one of the most important ways to value a company’s stock. Microsoft’s profit margin is 30%, which is beyond awesome. 10% is healthy, 20% is robust. (That comes with a caveat. We talked aboutdiscussed Walmart before, which is a corporate behemoth no matter how you measure it. Walmart’s profit margin is barely 4%, but you have to consider what industry it’s in. A retailer such as Walmart has to have tons of merchandise on hand, keep it on shelves, and hope people buy it for just a little bit more than it cost instead of going to a competitor. Microsoft doesn’t have to do that. Nor does it have that many competitors, as the Department of Justice tried to remind us in the late ‘90s.)
Alright, one more for making it this far. Congratulations:
So yeah, that’s an income statement. Understandably, you want net income to be positive, but not without comparing it to revenue—while considering what industry the company happens to be in.
And with that knowledge alone, you already know more about what makes a healthy investment than 90-something percent of blind speculators “investors” do. Next in the series, balance sheets. Try to contain yourself.