The income statement is all about showing whether you made or lost money during a specific period of time. However, it is important to remember that the income statement does not equal cash. In some cases, it can appear that you made a hefty profit, but have very low cash flow. This is due to different rules that allow accountants to record revenues even if they still didn’t get the money (e.g. sales on credit).
Revenue or sales, it’s the same thing. It refers to the dollar amount of goods or services that you sold. It is calculated as price (P) * quantity (Q). Imagine you are selling pens. If the price of one pen is $2 and you sold 10,000 pens, then your total revenue will be $20,000.
Cost of Goods Sold (COGS)
In order to sell something, you have to have it first. Cost of goods sold refers to the dollar amount of how much you paid to buy/produce the goods or services that you sold. If you sold 10,000 pens and each pen cost you $1 to produce or obtain, your COGS will be $10,000.
Gross Profit refers to the difference between Revenue and COGS. Gross Profit margin, defined as Gross Profit divided by Revenue, tells you how much money you’re making on every dollar of your sales before accounting for other operating expenses. This part of the income statement gets a lot of attention since a company’s Gross Profit determines how much money is leftover to spend on important areas such as marketing, research & development, and other operating expenses.
Operating Income / EBIT (Earnings Before Interest & Taxes)
Operating income or EBIT refers to the income you make purely from your operations. It is calculated by subtracting all of your operating expenses (expenses that relate to what you need to do to run the business) from the Gross Profit. Notice that operating income does not include cost of financing (e.g. interest payments on long term debt). This is a very important number in the analysis because it relates to the actual business aspect, not accounting for capital structure (the debt held).
Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA)
Although this is not an explicit line on the income statement, EBITDA is an extremely important measure in investment banking. It is a pretax proxy for operating cash flows. Just like EBIT, it is used primarily to compare businesses on an operating level. The only difference between the two is D&A (depreciation and amortization), which are added back to EBIT because they are non-cash expenses on the income statement.
Net income (the bottom line) accounts for all the money you made and all the expenses you have to pay. Often times it can be misleading because it incorporates costs of financing (see below).
Although both companies have the same operating earnings, they report a different net income because company A has to pay interest on its debt. This is why net income is not a good representation of a core business.