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Understanding the Income Statement

In this new series, MagicDiligence will investigate how to analyze a company's financial statements, what information each statement is intended to convey, a description of most line items you will see, and a list of red flags to be aware of. In this first entry, we'll examine the income statement.

The purpose of the income statement. The income statement's purpose is to provide investors the most accurate description of the company's profitability over a set period of time, usually a fiscal quarter (three months), or a fiscal year (12 months). This includes an estimate of the firm's sales, costs, increase or loss in intangible value, taxes, outstanding shares, and how the resulting net profit is divvied up to shareholders.

It's important to emphasize that the income statement is an estimate of these figures. Some items, such as the value of goodwill (which will be discussed in the balance sheet article), or depreciation expense, are essentially arbitrary. Even seemingly concrete figures, such as revenues, are estimates as some companies will book sales based on commitments which may later be amended or even terminated. The income statement is full of accounting assumptions. When we discuss the cash flow statement, we will see how these assumptions translate into cold, hard cash.

For this series of articles, we'll use the financial statements of a recent (although not current) Magic Formula stock that everyone should be familiar with: Intel Corporation (INTC). Intel has a fairly easy to understand business, and also has most of the line items an investor will encounter when investigating a stock. Here is Intel's fiscal 2007 income statement (all values are in millions of dollars). Columns with grey backgrounds are a calculated (not reported) value, and those with light blue backgrounds are calculated metrics. Values in parenthesis represent costs.

Cost of Sales(18,430)
Gross Profit19,904
Gross Margin51.9%
Research and Development(5,755)
Marketing, General and Administrative(5,401)
Amorization of Intangible Assets(16)
Operating Income8,732
Operating Margin22.8%
Net Interest Income/Expense793
Restructuring and Asset Impairment(516)
Gains on Equity Investments157
Income Tax Provision(2,190)
Net Income6,976
Net Margin18.2%
Shares Outstanding5,936
Earnings Per Share1.18

Let's take each of these line items one-by-one and explain them briefly:

Revenues. This is simply the amount of money Intel earned in 2007 from selling their processors, chipsets, and memory to customers, primarily electronics manufacturers.

Cost of Sales. These are the direct costs of producing the processors, chipsets, and memory products. Things included in this number would be manufacturing employee salaries, the cost of silicon and other materials to build the chips, electricity and other utilities to run the fabs, packaging materials, and so forth.

Gross Profit. Gross profit is simply (Revenues - Cost of Sales).

Gross Margin. Gross margin is (Gross Profit / Revenues). This gives an idea of how much of each dollar of sales the company earns from selling it's products. Most commodity industries earn low gross margins (20% or lower), while highly differentiated products can earn very high gross margins (50% or more).

Research and Development. In order to consistently produce faster and smaller chips, Intel has to spend a lot of money on development labs, engineering resources, prototype products, etc. Those expenses are recorded here.

Marketing, General and Administrative. Remember the Blue Man Group commercials hawking Intel chips? Those and other advertising expenses are recorded here. General and Administrative costs include executive salaries, stock options, and any other costs that cannot be grouped elsewhere.

Amortization of Intangible Assets. Intangible assets will be discussed more in the balance sheet article, but in general they are assets like brand names, exclusivity contracts, or patents that provide competitive advantage but are difficult to place a price tag on. In this line, Intel is applying a pre-defined schedule for degrading the value of these. This is one of those accounting assumptions that does not involve any cash, just the paper value of the company.

Operating Income. Operating income is (Revenues - All Operating Costs). This is the golden number on the income statement. These are the profits Intel earned from it's day-to-day business in the fiscal year.

Operating Margin. Calculated by (Operating Income / Revenues). Operating margin is very useful for comparing companies with the same general business. Higher operating margins between competitors usually indicates which company has the stronger business.

Net Interest Income/Expense. Intel owes it's bondholders interest on the $2 billion in debt it has issued, but also collects interest on the nearly $12 billion of cash and other investments. Since Intel collects more interest than it pays, this value is positive.

Restructuring and Asset Impairment. When a company decides to cut costs by announcing layoffs, usually the cost of laying off these workers (for severance pay and so forth) is expensed right away. Asset impairment is often related to equity investments the company holds. When it believes that the investment will no longer be worth it's booked value within a reasonable amount of time, it will record an "impairment" to a lower level. Again, this is an accounting assumption that may or may not turn out to be accurate, for better or worse!

Gains on Equity Investments. Intel holds significant equity stakes in IM Flash Technologies and Clearwire, the latter of which trades on the NASDAQ Global Select. The change in value of this investment over the fiscal year is recorded here. Once again, this is not a cash item and really has no effect on the day-to-day business of the company.

Income Tax Provision. Like all of us, Intel has to pay Uncle Sam. The accountants calculate what they believe the tax rate will be and set aside a portion of profits in this line item (another assumption!).

Net Income. Net income is simply (Revenues - All Costs). This is the bottom line profit number.

Net Margin. Net margin is (Net Income / Revenues). This represents the percentage of each dollar that falls through to profits. Intel's 18% figure is exceptional. Net margin, like operating margin, is most useful when comparing two competitors in the same industry.

Shares Outstanding. This is the average number of common shares outstanding through the period. If you are a shareholder, some of these shares are yours.

Earnings Per Share. Simply (Net Income / Shares Outstanding). This is the amount of profit the company earned for each one of your shares.

So that's the income statement. Next we'll examine the balance sheet, followed by the cash flow statement. Then we'll finish up with a list of accounting "red flags" to look for when examining a company's statements.

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