How to read an income statement

The top line is what customers were billed for goods and services delivered during the period, which is not the same as what the company was paid. Revenue is recognised when the obligation is met, so a company can book revenue in March for cash that arrives in July, or take cash in March for revenue recognised across the following year.

That gap is normal and is where a lot of interesting behaviour lives. A business whose receivables grow much faster than its revenue is collecting more slowly than it is selling.

Cost of revenue is what it directly cost to deliver what was sold. Subtract it and you have gross profit, and as a share of revenue, gross margin.

Gross margin is the cleanest read on pricing power available on this statement. It varies enormously between industries and barely at all within one, so compare it against the company's own history and against direct competitors, never against the market.

• Where a company draws the line between cost of revenue and operating expense is partly a policy choice, so two companies in one industry can classify differently.
• Some businesses, including most banks and insurers, report no cost of revenue at all, and gross margin is meaningless for them.

Below gross profit sit the costs of being a company rather than of delivering the product: research and development, sales and marketing, general and administrative. Subtract them and you have operating income, which is what the business earns from operating, before the effects of how it is financed or where it is taxed.

This is the number to compare across companies with different debt loads, because it sits above interest. It is also where stock-based compensation lives, which matters: it is a genuine cost here, and the cash flow statement will add it straight back.

Interest reflects the financing decision, tax reflects jurisdiction and structure, and what survives both is net income. It is the most quoted line and the least comparable one, because two identical businesses financed differently will report different net income.

Net income divided by the diluted share count gives earnings per share, which is the figure the market reacts to and the one most sensitive to the share count moving underneath it.

Put three to five years side by side and read across rather than down. The questions worth asking are about direction and consistency, not about any single period.

• Is revenue growing, and is the growth organic or acquired?
• Is gross margin stable, and if it moved, do you know why?
• Is operating margin widening as revenue grows, which is scale, or flat, which is not?
• Does net income track operating income, or is something below the operating line doing the work?