FOOL'S SCHOOL DAILY Q&A

Secrets of the Income Statement

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By Selena Maranjian (TMF Selena)
April 2, 2003

Q. What should a company's income statement tell me?

A. If you're new to investing (and even if you're not), you've probably stared at an income statement (sometimes called a "statement of operations" or "profit and loss statement") and scratched your head, wondering what it's telling you. Be puzzled no longer.

The income statement summarizes sales and profits over a defined period of time. It might cover three months or a year, for example. It will usually offer information for the year-ago period as well, so you can compare the two and spot trends.

Let's look at the income statement for fiscal year 2002 for Coca-Cola (NYSE: KO). We'll compare our findings with some numbers from PepsiCo's (NYSE: PEP) 2002 income statement. Just remember that the two companies are not identical -- while Coca-Cola is pretty much just a beverage company, PepsiCo's business includes substantial snack operations (from Frito-Lay, for example).

At the top, as with every income statement, you'll find net sales (sometimes called revenues). Coca-Cola's "net operating revenues" are $19.6 billion. From now on, as we work down the income statement, various costs will be subtracted from the revenues, leaving different levels of profit. These are called "margins" and are an important item for investors to evaluate.

The item you'll find just under revenues is "cost of goods sold" (sometimes abbreviated as COGS or called cost of sales), which represents the cost of producing the products or services sold. For Coca-Cola, it's $7.1 billion. Subtract the COGS from revenues, and you'll get a gross profit of $12.5 billion.

To find the gross profit margin, simply divide the gross profit by revenues -- $12.5 billion divided by $19.6 billion yields a gross profit margin of 64%. Compare results with industry peers. For example, the gross margin for PepsiCo is 60%.

Next, the remaining costs involved in operating the business, such as support staff salaries, utility bills, and advertising expenses are subtracted, leaving the operating profit (or "operating income"). Coca-Cola's operating profit is $5.5 billion. Divide this by revenues, and you get a healthy operating margin of 28%. This reveals the profitability of the company's principal business (PepsiCo: 19%).

Finally, after items such as taxes and interest payments are accounted for, we come to net income, near the bottom of the statement. Coca-Cola's is $3 billion. Divide that by revenues and you get a net profit margin of 15% (PepsiCo: 13%). The last part of the income statement is where the company divides its net income by shares outstanding, to arrive at earnings per share (EPS).

Compare all these margins with those from previous years. Increasing margins indicate increasing efficiency and profitability. Check out the margins of the company's competitors. Is the firm more efficient than its peers? Look for significant changes in revenues, SG&A (selling, general, and administrative) expenses, and costs of goods sold.

And, finally, note that margins vary widely by industry. Software companies, for example, tend to have high margins, while retailers tend to have low ones. Wal-Mart (NYSE: WMT) is proof that a company can do phenomenally well for itself and its investors despite low margins. It just makes up for them with high volume.

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This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.