Lesson 2 of 10
The income statement
What each line subtracts, why where a cost sits is a reporting choice, and how reporting a sale gross or net can multiply revenue without moving profit.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The income statement subtracts costs from revenue in a fixed order, ending at net income.
- Where a cost sits above or below gross profit is a reporting choice, not a rule, so gross margins are not always comparable.
- Reporting the same sale gross or net can multiply revenue many times over, tenfold in the example below, with no change to profit.
The income statement answers one question: did revenue exceed the cost of earning it, in this period. A fixed order of subtractions answers it, and two choices behind those lines can move a margin without moving a single cash flow.
From revenue to net income
- Revenue$1,000
- Cost of revenue−$600
- Gross profit= $400
- Operating expenses−$260
- Operating income= $140
- Interest and tax−$35
- Net income= $105
The order, and what it isolates
Revenue is recognised when the company satisfies its obligation to the customer, usually not when the cash arrives. Cost of revenue, the direct cost of producing what was sold, comes off first to leave gross profit: the money available for everything that is not production. Operating expenses, selling costs, administration and research, come off next to leave operating income, the profit of running the business before any question of financing or tax. Interest and tax come off last.
Where a cost sits is a choice
The line a cost is reported on is not fixed by what the cost is. Production depreciation, distribution costs and some payroll can sit inside cost of revenue or below it, and the choice is the company's own classification policy, disclosed in a note rather than imposed by a rule.
Take the company in the figure. Move 80 of distribution costs from below the line to inside cost of revenue, and gross margin falls from 40.0 percent to 32.0 percent, eight points. Operating income and every cash flow stay exactly the same. A gross margin is safe to compare against the same company's own history, as long as its classification policy did not change. Across companies it is only safe once you have read the policy note, which is why operating income, sitting below the choice, is the steadier subtotal for that comparison.
Gross or net can multiply revenue
ASC 606, the US rule for recognising revenue, also decides whether a company reports revenue gross, as the principal in the transaction, or net, as an agent collecting a fee. The conclusion is a judgement about the company's role, and it can move revenue by an order of magnitude with no change to profit.
What this statement will not tell you
It does not say whether the profit arrived as cash: the cash flow statement answers that. It does not say how much capital the profit needed, and a 10 percent margin earned on assets of 500 is a different business from the same margin earned on assets of 5,000. Disposals, impairments and legal settlements often sit inside ordinary lines, and what they were is explained in the notes.
Check yourself
Two companies have identical cash flows and gross margins eight points apart. What is the most likely reason?
- One company is misreporting its results
- They classify a cost differently above or below gross profit
- One company earns a higher return on its assets
Show the answer
Answer: B.
The line a cost sits on is a classification choice disclosed in a note, not a rule. It changes gross margin without changing operating income or any cash flow.A company reports one sale as principal instead of as agent. What happens to operating income?
- It rises
- It falls
- It stays the same
Show the answer
Answer: C.
Principal and agent reporting move revenue and cost of revenue by the same amount, so gross profit and operating income are unchanged. Only revenue, and every ratio built on it, moves.Which subtotal is safest to compare between two companies with different debt loads?
- Gross profit
- Operating income
- Net income
Show the answer
Answer: B.
Operating income sits below the classification choice above gross profit and before the financing and tax decisions that net income carries.Sources
- ASC 606, Revenue from Contracts with Customers, including the principal versus agent guidance on reporting revenue gross or net.
What this leaves out
- Banks and insurers present a different statement entirely, with no cost of revenue and no gross profit line, and the readings above do not transfer to them.
- It does not cover the statement of comprehensive income, which sits alongside this one and can carry more than net income in a year a currency or a discount rate moves sharply.
- There is no cross-industry standard for what level of margin is good, and the classification choice above means there is not always a within-industry one either.
- The worked example uses round invented numbers so the arithmetic can be checked by hand. Nothing here is advice about any security.