Total Revenue

To understand Income Statement, let’s begin with the example of Navya, who has been running 3 pizza outlets, named “Roma”, in different parts of her city since the last 3 months. Her outlets are located in strategic locations and attract a lot of people, leading to high sales. It is now time to file taxes and she has to prepare the income statement, balance sheet and cash flow statement of her business to understand whether she has made profits or losses during the previous financial quarter and to understand what her business owns & owes.

The income statement helps understand a company’s performance over a specific period of time. Let’s assume a time frame between 1st January 2018 and 31st March 2018. An income statement helps us understand how much money the business earned, during that specific 3-month period, by selling the goods/services it produced. It also lists out the expenses that the company incurred during the specific period and finally arrives at the profit loss number.

Let us discuss various items in these financial statements to understand them better.

Total revenue

Revenue is the income that a business earns by selling merchandise or offering specific services. It is also referred to as sales or turnover. Revenue is calculated for a specific period like a quarter or a year. Revenue is calculated after adjusting for discounts and product returns.

Let’s suppose between 1st January 2018 and 31st March 2018, Navya sells 10,000 pizzas and the price of each pizza is Rs.200. Her revenue earned during the quarter would be Rs.20,00,000 (10,000 * 200).

Looking at a company’s revenue is important because companies that are able to increase their sales year after year are desirable.

In case of industrial and utility companies, the total revenue is calculated as revenue from all of a company’s operating activities after deducting any sales adjustments.

In case of insurance companies, the total revenue is the total insurance related premium that the company has earned during the period.

In case of banks, total revenue is the sum of interest and non-interest income earned by the bank. Non-interest income includes fees & commissions, credit card fees, foreign currency gains etc.

Cost of Revenue

Cost of revenue is the cost directly incurred in producing the product sold or services rendered. This amount includes the cost of the materials used in creating the product along with direct labor charges and other costs, like electricity expense, directly incurred in producing the product or service. Only direct costs incurred are considered here. Just like revenue, the corresponding cost of revenue is also calculated for a specific period like a quarter or a year. In fact, all income statement items are calculated for a similar time period.

Let’s suppose the raw material required to make a pizza – dough, cheese, vegetables etc – together cost Rs.50 per pizza. Electricity charge incurred in running the oven is Rs.30 per hour and the employee making the pizza gets paid Rs.20 for every pizza he makes. Assuming 6 pizzas can be made in an hour, the electricity charge incurred in making each pizza is Rs.5 (30/6). The cost of revenue is Rs.75 per pizza (50 + 20 + 5). So during the 1st quarter of 2018, Navya’s total cost of revenue was Rs.7,50,000 (10,000 * 75).  

Companies that are able to either maintain or decrease their cost of revenue in relation to their sales are desirable.

In case of industrial companies, the cost of revenue is calculated as total operating expense directly related to the goods and services provided. In case of utility companies, along with direct operating expense, operations & maintenance as well as fuel expense is considered.

In case of insurance companies, cost of revenue includes losses & benefits paid to policyholders, underwriting commissions and reinsurance expense.

In case of banks, cost of revenue is the sum of the total interest expense and non interest expense. Total interest expense is the interest paid on deposits and other borrowings. Non interest expense includes labour costs, foreign currency loss, litigation expense etc.

Gross Profit

Gross profit is the difference between total revenue and cost of revenue. It is the profit a company makes after deducting the cost directly associated with making the good or providing the service.

In the example above, the gross profit would be Rs.12,50,000 (20,00,000 – 7,50,000).

Companies that are able to increase or at least maintain their gross profit in relation to sales are desirable.

Operating Costs

This is the cost incurred in administering & maintaining a business on a day-to-day basis. It is the amount expended by a company just to maintain its existence.

Suppose Navya pays Rs.10,000 every month to the manager of each of the pizza outlets, Rs.2,000 every month as cleaning charges of each outlet, and Rs.5,000 towards other sundry expenses, then the operating expense of her company would come to Rs.41,000 every month (10,000 * 3 + 2000 * 3 + 5000). Hence, the total operating expense during the quarter was Rs.1,23,000 (41,000 * 3).

Just like in case of cost of revenue, companies that are able to either maintain or decrease their operating costs in relation to their sales are better.

In case of industrial and utility companies, operating expense is calculated as the sum of selling & general expenses, research & development costs, unusual expenses like restructuring charge & litigation expenses and any other operating expense resulting due to foreign currency adjustments, etc.

In case of insurance companies, the operating expense is calculated as the sum of selling & general expenses, unusual expenses like restructuring charge & litigation expenses and any other operating expense resulting due to foreign currency adjustments, etc.

In case of banks, loan loss provision is a part of the operating expense head. Loan loss provision refers to the provision created for the possible default on loans given out by the bank.

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation and amortization. EBITDA is a measure of the company’s operating performance. This data item helps understand the profits generated by the company via its operations.

In Navya’s case, EBITDA is calculated as gross profit minus operating costs. The amount of EBITDA is Rs. 11,27,000 (12,50,000 – 1,23,000).

Companies with higher EBITDA in relation to their sales are better than companies with lower EBITDA in relation to sales.

Depreciation/Amortization

Depreciation is the planned and gradual reduction in the value of a fixed asset over its useful life. Depreciation is applied to fixed assets like cars, computers, machinery etc, as these assets lose their value as well as utility over the years.

Amortization works on the same principle as depreciation and is applied to intangible assets like patents, copyrights etc.

Let’s say Navya buys a new car for Rs 6,00,000 at the start of the year for business use. If after using it for a year she attempts to sell the same at the end of the year, the resale value will definitely be lower than the purchase price of Rs 6,00,000. The resale value is the depreciated value of the car and the difference between the original purchase price and the resale price is the amount of depreciation. Even if Navya does not want to sell the car, she will reduce the value of the car each year in her books and mark the amount of reduction in her profit and loss statement as depreciation expense. Let’s assume that Navya marks Rs.60,000 each year as depreciation; the quarterly depreciation will be Rs.15,000.

While industrials, utilities and insurance companies mark depreciation, banks usually have very few fixed assets and hence do not mark depreciation.

PBIT

PBIT stands for profit before interest and taxes and is calculated as the difference between EBITDA and depreciation & amortization.

Navya’s PBIT is Rs.11,12,000 calculated as 11,27,000 minus 15,000.

Interest & Other Items

Interest expense refers to the amount of interest paid by the business on borrowed funds. Suppose Navya had borrowed Rs.12,00,000 from a bank at an interest rate of 10% per annum to fund her business. Rs.1,20,000 (10% * 10,00,000) is the annual interest expense and Rs.30,000 is the interest expense each quarter.

PBT

PBT stands for profit before taxes and is derived by subtracting interest & other items from PBIT.  In Navya’s case PBT will be Rs.10,82,000 (11,12,000 – 30,000).

Taxes & Other Items

This is the tax on profit earned that a company owes to the government. This tax is very similar to the income tax that an individual pays on his income. In India, a flat 25% tax is levied on profits earned by domestic companies.

Navya’s pizza company has earned Rs.10,82,000 profit before tax during the first quarter. Assuming a 25% tax rate, the tax amount will be Rs.2,70,500 (10,82,000 * 25%).

Net Income

Net income is the profit earned by the company from its business operations after accounting for all operational & non operational expenses, interest costs and taxes. It is the amount of money that is available to the shareholders of the company after accounting for all kinds of cost associated with running a business venture.

Navya earned a net profit of Rs 8,11,500 (10,82,000 – 2,70,500) during the first quarter of the year.

Companies with higher net income in relation to their sales are better than companies with lower net income in relation to sales.

EPS

Calculating earnings per share (EPS) involves 2 different items–net income and total common shares outstanding. EPS is calculated as net income divided by total common shares. It represents the portion of a company’s profit that can be allocated to each outstanding common share of the company. The higher the earnings per share of a company, the better is its profitability.

Companies that are able to increase their earnings per share year after year are desirable.

Navya’s company, Roma has issued 10,000 shares of common stock and the net profit earned during the first quarter is Rs.8,11,500. Hence, the EPS is Rs.81.15 (8,11,500 / 10,000).

DPS

When a company earns profits, it can either decide to retain the same and invest it in the business or distribute the profits to the shareholders of the company. This distributed profit is called dividend. Dividend per share (DPS) is calculated as total dividend divided by total common shares. It represents the portion of a company’s profit that has been paid out to each outstanding common share of the company.

From the previous example, we have seen that common shares outstanding is 10,000 and the EPS is Rs.81.15. Suppose the company decides to pay 25% of its EPS as dividends, the DPS would be Rs.20.3 (81.15 * 25%).

Payout Ratio

Payout refers to the amount of profits of the company that has been paid out as dividends and has not been utilised in the business.

Payout ratio is calculated as dividend per share (DPS) divided by earnings per share (EPS) and is typically expressed as a percentage. Suppose the EPS is Rs.10 and Rs.2 is paid out as DPS, the payout ratio would be 20% (2 / 10 *100).

Research & Development

Research & development (R&D) expense refers to the cost associated with the research & development of a company’s goods and/or services. R&D activities involve conducting systematic research in order to attempt to discover specific solutions to a problem or create a new product.

R&D expense is usually very high in fields like pharma, oil & gas and specific kinds of technological firms. When assessing companies from these sectors, it is important to check whether R&D expense on an absolute basis as well R&D expense in relation to sales is increasing or at least stable. A company that does not invest sufficiently in R&D will lose its competitive advantage over a period of time as it will not be able to develop any new product or service.

Selling/General/Administrative Expenses

As the name suggests, selling, general and administrative expense (SG&A) refers to the expenses incurred in administering a business as well as selling the products/services created by it.

General & administrative costs include all expenses incurred in operating a business other than the cost directly incurred in producing the product sold or services rendered. Items like salaries of top executives & office staff, rent of office building, auditor fee etc. are part of this head.

Selling expense includes the cost of advertising and other promotional expenses.

Interest Income

Interest income is the sum of all interest earned by the bank either via any kind of lending or investing activity. This includes interest & fees on loans made out, interest & dividends from investment in various securities, interest income earned from deposits with other institutions, returns earned on trading account security etc.

A bank/financial institution (FI) that is able to increase its interest income every year is desirable.

Total Interest Expense

The item total interest expense is specific to banks and non-banking financial institutions. It is the sum of interest paid on deposits from customers as well as interest paid on borrowings from other sources via bonds & notes issued.

A bank/financial institution (FI) that is able to maintain or decrease its interest expense, every year, in relation to its interest income is desirable.

Net Interest Income

Net interest income is specific to banks and non-banking financial institutions and is defined as the difference between interest income, bank and total interest expense. It is the difference between the sum of all interest incomes of the bank and the sum of all of its interest expense. 

Loan Loss Provision

Loan loss provision refers to the provision created for possible default on loans given out by the bank or financial institution.

Banks and financial institutions lend to a wide range of customers like individuals, medium & small enterprises (MSME) and giant corporations. Due to a range of reasons, some of these loans might not be returned, i.e they might turn bad and in other cases, loans might not be returned on time. Hence, in order to cover these possible losses, the bank sets aside a portion of the repaid loan amount. The loan loss provision acts as an internal insurance fund.

Net Interest Income after Loan Loss Provision

This amount is the difference between net interest income and loan loss provision. It indicates the gains from loan operations of the company after considering the cost of the loan and providing for unexpected losses via loan loss provisions.