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The financial report that receives the most attention from companies, investors and business reporters is the income statement. Every quarter and at fiscal year-end, a public company issues an income statement showing performance for the just-concluded time period.

The income statement shows what the company generated in profits or losses during the period. The report, also referred to as a statement of earnings or an earnings statement, answers this question: How much did the company gross and net during the period?

Since companies regularly issue earnings reports, more business stories are probably based on the income statement than on any other document. Many reporters write these stories directly from the company earnings release and don’t provide any real reporting or analysis.

If you are not familiar with all of the terms below, buy a reference book like The Dictionary of Finance and Investment Terms by Downes and Goodman or access web sites like The Motley Fool, Investopedia, Morningstar and Finance.Yahoo for quick help with definitions.

The 2007 income statement for U.S. cereal giant Kellogg Company provides an excellent real-world example of the terms I’ll be discussing in this column. Not all income statements, however, use the same terminology, but most will generally follow the format below.

Key categories found in the income statement include:

• Revenues, gross revenues, net operating revenues, net sales or sales: These are the company’s revenues from all sales for a certain time period. Kellogg calls this category net sales and recorded US$11,776 billion in sales for 2007. This entry is often referred to as the “top line.”
• Cost of goods sold (CGS): For a manufacturer, this typically includes the cost of inventory (raw materials and supplies to make the company’s products), as well as the expenses of turning raw materials into finished products, such as labor and direct overhead. For a retailer, this category is what the company pays for the products it sells on its shelves. It is only the cost of the merchandise purchased for resale, not the cost of providing the service to customers. Since a service company does not sell a product, this category is typically small. Kellogg reported US$6,597 billion in CGS in 2007.
• Gross profit: Revenues minus cost of goods sold result in “gross profit.” Most companies pay special attention to managing the gross profit as a percentage of revenue, or what is called the gross profit margin. Kellogg does not show a category of “gross profit,” but we can calculate it by subtracting CGS from revenue, to get US$5,179 billion for 2007.
• Operating expenses: Most companies present operating expenses in a category called “selling, general, and administrative expenses” or SGA. Operating expenses typically include rent, salaries and wages paid; payroll taxes; property taxes; telephone; insurance; research and development; depreciation and amortization; and bad debt expense. For Kellogg, its SGA was US$3,311 billion for 2007.
• Operating income or operating profit: Gross profit minus operating expenses (SGA) yields “operating income.” Operating profit expressed as a percentage of revenue is called operating profit margin. For Kellogg, the operating profit was US$1,868 billion for 2007.
• Interest expense or income: Companies pay interest on loans and earn interest on investments. Kellogg paid US$319 million in interest expenses for 2007. Note that the amount US$319 on the Kellogg statement is negative, although it does not have a minus sign or is not in parentheses (the usual notation for negative in financial statements). In this case it is negative because the interest entry is usually, but not always, negative.
• Other income or expenses: Includes items such as discontinued operations, sale of an investment, unusual or extraordinary items, changes in accounting principles, and minority interest. Kellogg had US$2 million in other expenses in 2007.
• Income before income taxes: Deducting the other revenue/expenses and interest income (expense) from operating income yields income before income taxes. Kellogg reported US$1,547 billion in income before income taxes for 2007.
• Income taxes: The amount of income tax the company paid that year. Kellogg paid US$444 million in taxes in 2007.
• Net income: Net income is what’s left after all expenses have been deducted. This is often referred to as the “bottom-line.” Kellogg reported US$1,103 billion in net income for 2007.
  

What it means
So, which numbers are important? Let’s start by saying that no one number is the most important. Typically, companies are most concerned with revenue and net income. They want to see both metrics rising at a steady rate, with net income rising at a more rapid rate. In addition, if a company reports much in the way of “other income or expenses,” operating profit becomes more important than net income. To learn more about most of the entries, look in the footnotes to the financial statements, which explain entries in excruciating detail.

Most income statements contain several other pieces of information related to company performance. They include:

• Earnings per share: Analysts and stockholders like to know how much of a company’s profit could be allocated to each share of common stock. In general, earnings per share (or EPS) is determined by dividing net income minus any preferred dividends by the average number of common shares outstanding for the period. (Not all companies have preferred stock or preferred dividends.)
  
  EPS is calculated for “basic” and “diluted” earnings. For basic EPS, net income minus any preferred dividends is divided by the average number of shares outstanding for the period. For diluted EPS, net income minus any preferred dividends is divided by a number reflecting the possible conversion of all convertible securities to common stock, and if all warrants or stock options were exercised, for the period. For 2007, Kellogg reported US$2.79 for basic EPS and US$2.76 for diluted.
• Average shares outstanding: The average number of common shares outstanding for the report period. The number of shares can vary during the reporting year because options are being exercised, the company is buying back stock or the company is issuing new stock in the market. Although some income statements show the average shares outstanding, Kellogg’s does not. To find that number, refer to the footnotes in the financial statement.
  

Analyzing the numbers
A good rule of thumb when reviewing any financial statement is to look for changes in any category from year to year that seem out of the ordinary. For example, on the income statement, look first at net sales or operating revenues to determine if they went up or down. If they increased, did they increase faster than the previous year and/or faster than the rate of inflation? If sales lagged behind inflation, this could indicate the company may be having difficulty selling its products. Do the same analysis with net income.