Before you analyze any financial statement, you first need to understand what you’re looking at. Here’s an example of a simple income statement:

Let’s break that down. Revenue is the amount of money generated from selling products and services, and when you subtract the direct costs of making those products and services available – collectively called the cost of sales – you get gross profit (note that parentheses always indicate a negative amount, so (200) is the same as saying -200). If Apple retails iPhones for $800 which cost the company $500 to manufacture and sell in stores or online, it’ll make a $300 gross profit on each iPhone sold 👌

Operating expenses capture all the indirect costs associated with sales: marketing and advertising spends, for example, as well as the everyday costs of running the company. Subtract this from gross profit, and you arrive at operating income – which is basically the amount of profit realized before fiddly deductions like interest and tax expenses. Once we subtract these, we’ve got the final figure in the income statement: net income.

Investors often consider a company’s net income as a percentage of its revenue. This profit margin indicates how many cents of profit the firm makes for each dollar of sales – the higher the better. It’s even more informative if we compare that profit margin to the company’s peers’; consistently higher profit margins suggest a superior operation 🧐

Another common ratio – in this case used to assess a company’s financial health – is interest coverage, which is calculated by dividing operating income by interest expense. This ratio measures a company’s ability to “service”, or pay interest on, its outstanding debt – and once again, the higher the better.

To put all this analysis into practice, let’s try looking at the income statements of two hypothetical companies in the same industry: GoodCo and BadCo.

GoodCo has a lot here that you’d want to see as an investor. First, the company shows consistent revenue growth from year to year. Second, the firm has strong profit margins that are also expanding. That’s because GoodCo’s keeping its costs under control as it grows sales, meaning net income is rising faster than revenue. Third, the company has a healthy interest coverage ratio of over 6. That means it can pay its way six times over; existing debts aren’t an issue 😚

Now let’s look at BadCo’s income statement:

Uh oh: this is quite a contrast to GoodCo, and definitely not what you’d want to see as an investor. BadCo’s revenue growth is volatile from year to year and is trending negative over time. The company’s also working on razor-thin margins that are steadily shrinking – which is never a good sign. Lastly, its interest coverage ratio is significantly lower than GoodCo’s; if revenue takes a hit or costs rise, it may struggle to handle its outstanding debt 🙈