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Introduction to Financial Statement Analysis

Any good operator of a business, whether it’s an entrepreneurial start-up, an established company, or a nonprofit serving its community, must be able to understand the basics of accounting and financial statement analysis. Why? The reason is because accounting is the language of business. To communicate with other managers, suppliers, customers, lenders, and investors, you need a common language.

Furthermore, in order to make decisions about how to run the enterprise—Should I hire more people? Should I change my suppliers? Should I raise more money? Should I raise or lower my prices?—you need a common framework within which to organize the data required to make informed decisions. That framework—financial statement analysis—will be laid out in the coming chapters.

Our intent is not to turn you into an accountant. That takes years of study and deep understanding of arcane rules. Rather, we will give you the tools to be a successful operator of a business and put them into a clear conceptual framework based on real-world applications.


Learning Objectives: By the end of this chapter you will be able to:

  • Explain what information is shown on the three main financial statements
  • Explain how companies make money and how that is represented on the income statement
  • Calculate and interpret key financial ratios on the income statement
  • Determine a company’s condition by analyzing its income statement

The Business Model

All of the decisions that a manager makes about how a company operates—who are its customers, how it reaches them, how it creates its products or services, and so on—are the building blocks of a company’s business model. First, the business model shows how a company generates revenue by solving a customer’s problem. Then, the business model shows how a company creates the solution to that problem by assembling that product or service from inputs. Next, the company has to spend money to run the business—hire salespeople, develop new products, and pay rent. These are operating expenses. What is left after operating expenses are covered, so-called operating profit, can be used to reward other stakeholders in the business.

Most business analysts stop there when analyzing a business model, as this is what is shown on a typical income statement. However, this is only part of the story. As we will see, there are many other decisions that need to be captured. Those decisions show up in other financial statements. Before we move into the income statement, let’s get grounded on the three main financial statements and see what they show.

Sample List Items

  • List 1
  • List 2
  • List 3

The Three Main Financial Statements

The pictures in Figure 1 provide a visual sense for what the three main financial statements show.

Figure 1
Figure 1 (F01_001.jpg)

The Income Statement is like a movie. It tells a story of how a company makes money over a period of time. As we’ll see, there are many players in this movie, and there’s a surprise plot twist!

The Balance Sheet is like a snapshot. It shows what resources are needed to run the business and how those resources are paid for at a moment in time. The income statement and balance sheet are, therefore, closely related. Think of the opening frame of a movie—“A long time ago, in a galaxy far, far away”—as the opening balance sheet. As you eat your popcorn and watch the space opera unfold, the income statement is telling the story of how the players are interacting. The final scene (no medal for Chewie!) is the closing balance sheet.

The cash flow statement is like a lie detector. This statement is the least understood, but the most valuable, tool to understand a company’s business model. Why? As you will shortly see, the income statement and balance sheet have some fundamental limitations due to our accounting system. To foreshadow the plot twist, the income statement actually doesn’t tell you how much cash a company is making or burning. By contrast, the cash flow statement shows just that. Unless you are committing fraud and manufacturing your bank statements1, you can’t hide cash. As we will see, the ability of a company to generate cash is the single biggest evidence of its health and ability to create value for its stakeholders. We’ll cover this in greater depth later.

Figure 2
Large accounting firms signed off on financial statements that said the Madoff investment firm had billions of dollars in assets as well as an unlikely track record showing years of always-positive returns.
Large accounting firms signed off on financial statements that said the Madoff investment firm had billions of dollars in assets as well as an unlikely track record showing years of always-positive returns. (F01_002.jpg)

The Income Statement—The Movie

The income statement, also called the Profit and Loss Statement or P&L, tells the story of a company’s revenue, expenses, and profits or losses between two points in time. It also shows the decisions that managers make to operate the company.

The waterfall in Figure 3 is a visual demonstration of how this works. Now we’ll go through each level of the waterfall.

Figure 3
The Waterfall and the Income Statement
The Waterfall and the Income Statement (F01_003.jpg)

What is revenue?

Revenue (also called “sales” or “net sales”) is generated when a company delivers a product or a service to its customer. That sounds simple, but actually it’s a pretty complicated topic in accounting (Google “revenue recognition rules” if ever you are in need of a sleep aid). For our purposes, we will just assume that revenue is recognized (i.e., shows up on the income statement) when the good or service changes hands.

There are lots of different ways companies can generate revenue. Product companies such as Apple, Inc. sell products like phones and computers for a certain price. Their revenue is simply the number of units shipped multiplied by the price of that unit. Advertising companies, such as Facebook, Inc. and Snapchat, sell ads on their Web sites. Advertisers pay money to influence demand for their goods and services and pay Facebook and Snapchat each time the ad is shown. Service companies, such as consulting and law firms, are typically paid by the hour. Their revenue is simply their hourly rate multiplied by the hours worked.

Sample Test Added

  • Sample Text 1
  • Sample Text 2
  • Sample Text 3

Cost of Goods Sold and Gross Profit

In order to produce its product or service, the company must assemble inputs into a finished product that customers can actually consume. Those inputs generally fall into two buckets: labor and materials.

The labor component captures the cost of the workers that made the product. If you are running a factory, the wages of the factory workers are captured here. If you’re running a service business, such as a law firm, the wages for the lawyers are captured here as well.

The materials component captures the cost of all of the goods needed to make the product, such as cloth for a T-shirt maker, microchips for a computer maker, or (hopefully) beef for a fast food joint.

The sum of these inputs is called cost of goods sold. The difference between the price at which a company sells its product and what it costs to make that product is called gross profit.

Gross Profit=RevenueCost of Goods SoldGross Profit=RevenueCost of Goods Sold

This is perhaps the most important relationship a company can measure, as it illustrates how much its customers are willing to reward it for doing the hard work of putting together the product or service. In other words, gross profit tells you how much customers are willing to pay the company compared to just buying the raw inputs on their own and putting them together. If a company is perceived to add a lot of value, it will have a high gross profit. The opposite is also true.

Let’s look at this in another way. Gross profit is measured in dollars. It’s hard to compare the gross profit of companies of different sizes and to see how gross profit changes over time. Suppose we divide gross profit by revenue. This would show us how much of every dollar sold is converted into gross profit. This has a special name—gross margin—and is measured as a percentage.

Gross Margin=Gross ProfitRevenueGross Margin=Gross ProfitRevenue

Note: Concept Check 1: Understanding Gross Margin:

Gross margin tells us how much value a company is adding to its inputs. The more value a company adds to its inputs, in the eyes of its customers, the higher its gross margin. For example, the costs to produce an additional copy of software, such as an iPhone app, are extremely low, so the gross margins of a software company tend to be extremely high. By contrast, the costs to produce the phone itself (such as the glass screen, microchips, and casing) tend to be relatively high, so the gross margins of a hardware company tend to be low.

Let’s think about the food business. Which type of company would have higher gross margins, a supermarket or a restaurant? Why? [see answer in the Appendix]

Making it run

You have to spend money to make money. In order to support the company’s products, the company must spend money to create demand, hire salespeople, and create new products. These costs are called operating expenses and fall into three main buckets.

  • Sales and marketing costs relate to the cost of creating demand for the product or service through advertising and getting customers to buy it by hiring a sales force.
  • Research and development costs, typically called R&D, relate to the costs to design and develop new products or add features to existing products. You might think that these costs should be part of cost of goods sold. However, accounting rules dictate that R&D is expensed as an operating expense.2
  • General and administrative costs, also called G&A, cover everything that is required to run the company on a day-to-day basis, such as rent, utilities, insurance, and salaries for senior management. As a general rule, companies should try to spend as little on G&A as possible.

Understanding Operating Income

When you subtract operating expenses from gross profit, what is left is operating income. This is also called EBIT, which stands for earnings before interest and taxes. Operating profit is what a company has left over after running the business that can be used to pay off shareholders, lenders, and the government.

Here’s the formula:

Operating Profit=Gross ProfitOperating ExpensesOperating Profit=Gross ProfitOperating Expenses

In order to compare one company to another, as well as to see how a company is doing over time, it is also helpful to look at operating profit as a percentage of sales:

Operating Profit Margin=Operating ProfitRevenueOperating Profit Margin=Operating ProfitRevenue

Operating Profit Margin, or EBIT margin, not only tells us how well the company is doing, but it also tells us a great deal about the choices that management makes. Remember that a company’s gross margin is the result of how much its customers value its products. If a company prices its products too high, a customer won’t perceive much value and the company won’t sell much. If it prices too low, it leaves money on the table. In order to justify its gross margin, the company must invest in operating expenses to support demand for its products. It must invest in sales and marketing to create demand, as well as product development to create great products. Think of this relationship as a trade-off between creating value and maximizing efficiency. A great management team will understand how to invest enough in the business to justify a high gross margin, while not wasting money on unnecessary operating expenses that don’t create value for customers.

Nothing is as certain as debt and taxes

After calculating operating profit, the next step is to remove the costs of any money the company has borrowed. This is called interest expense. As we will see later, borrowed money has a cost. To calculate that, we simply take the interest rate and multiply it by the debt balance:

Interest Expenses=Interest Rate × DebtInterest Expenses=Interest Rate × Debt

This shows up on the income statement below operating profit. Note that any repayment of the debt shows up somewhere else3. After deducting interest expense and making any other adjustments, what is left is pre-tax profit.

If the company has positive pre-tax profit, the government will also take a piece of the pie. In the United States, companies typically pay 30–35% of their profits in taxes.

Taxes=Pretax Profit × Tax RateTaxes=Pretax Profit × Tax Rate

Nothing but net . . .

After deducting taxes, what is left is net income:

Net Income=Operating ProfitTaxes and Interest ExpenseNet Income=Operating ProfitTaxes and Interest Expense

Net income is a very important number to understand. It shows how much profit is left from sales after deducting all of the costs of making the product or service, getting it into the hands of customers, keeping the lights on, and paying for debt and taxes.

As before, in order to compare one company to another and track a company over time, we typically divide net income by revenue to find net margin:

Net Margin=Net IncomeRevenueNet Margin=Net IncomeRevenue

Net income and net margin tell us how much profit is available to reward to owners of the business, the shareholders, as well as how much is available to reinvest in the company. These metrics are also excellent ways to measure the success and effectiveness of management.

Now here’s the twist. Net income is not cash!

Distortions of the matching principle

Our accounting system4 forces us to make choices as to when something actually shows up on the income statement as revenue or as an expense. For example, we recognize revenue when the product is delivered to the customer, even though the cash from that sale may be received at a much later date. We recognize the cost of goods sold of a product when the sale takes place, even though the product might have been sitting on the shelf for months. We owe thanks for these distortions to the matching principle. This states that expenses are only recognized when the associated sale takes place and that expenses should be recognized in the period in which they are incurred (i.e., “when they happen”). The problem is that there is quite a bit of subjectivity involved in determining when something actually “happens.”

The matching principle is supposed to provide a more accurate representation of the “economic substance” of a transaction. While this sounds like a noble goal, the consequences are severe as it can lead to major distortions in a company’s financial statements. Let’s look at two examples.

Example: Depreciation

How would you recognize the cost of a new factory? Here are some facts:

  • It costs $10 million to build a new plant
  • You spend the cash to build the plant in the first year
  • You expect the plant to run for 10 years

You might think that you would show the cost of the factory in the first year because that is when the cash is going out the door. In reality, the matching principle forces us to spread the cost of the plant over its expected useful life. So rather than showing a $10 million expense in year 1, our income statement would show a $1 million expense each year5. This expense is called depreciation and represents the usage of the factory over time. The twist is that depreciation is a “non-cash” expense. It shows up on the income statement as an expense but has no impact on cash flow. In effect it artificially depresses net income.

Example: Inventory

A product company has to put together products that its customers will buy. Suppose that a clothing retailer expects to sell a lot of green and orange plaid scarves over the holiday season. It pays its suppliers cash for the scarves and then puts them into inventory in its warehouse and on its store shelves. This initial purchase has no impact on the income statement. In fact, thanks to the matching principle, the cost of those scarves only shows up when a customer actually makes a purchase. If it turns out that the store has guessed badly and no one really wants those scarves, the goods may wind up sitting in the warehouse for years and never show up on the income statement. Talk about distortions!

Note: Concept Check 2: Understanding The Matching Principle:

The matching principle tells us that revenue is recognized when the product or service is delivered. When you subscribe to a magazine, you typically pay up-front for it. As the publisher of the magazine, when would you recognize the revenue for that sale, and how would you treat the cash you received for the subscription in advance? [see answer in the Appendix]

We will dig into these issues in much greater depth in the following chapters when we look at the balance sheet and cash flow statement. We’ll see that it is critical to understand how a company actually generates cash. Unfortunately, as we have now seen, the income statement has major limitations in this area because of the matching principle.

Key ratios for understanding an income statement

Now that we’ve completed our review of the income statement, let’s take a step back and review what we’ve learned so far. We can see that there are three main ratios that can be used to analyze a company:


When you analyze a company for the first time, you should immediately start thinking about these three ratios to gain insight into how the company is doing. Let’s look at some applications of these techniques.

Using ratios: common size income statement analysis

Which company is creating more value?

Table 1
($ in millions) TechCo RetailCo
Revenue $120 $150
Gross Profit $ 88 $ 40
Operating Expenses $ 68 $ 20
Operating Profit $ 20 $ 20

Our initial instinct might be that since both companies have the same level of operating profit, $20 million, they are each creating the same amount of value. As a budding savvy manager, you know better. You could just calculate the three ratios described above. However, you would lose some important information about how the business is being run. Let’s divide each number by the revenue in that year. This technique has a name: the common size income statement.

If we divide each number in each column by that column’s revenue, we get the following:

Table 2
  TechCo RetailCo
Revenue 100.0% 100.0%
Gross Profit 73.3% 26.7%
Operating Expenses 56.7% 13.3%
Operating Profit 16.7% 13.3%

Let’s ask the question again. Each entry is now calculated as a percentage of sales (i.e., as a margin). It now becomes clear that TechCo has significantly higher gross margins, 73.3% vs. 26.7%. Also it is spending significantly more on operating expenses as a percentage of sales, 56.7% vs. 13.3%, to support that high gross margin. When the dust settles though, TechCo has a slightly higher operating profit margin, 16.7% vs. 13.3%, which indicates that it is creating more value, all else being equal, that can be shared with investors, pay lenders, or reinvested in the company. Note that at this point we’ve told you nothing about what resources are required to create and run each company. These are critical metrics that we’ll explore in the next chapter.

Common size statements such as these are a great way to compare companies to each other both within and across industries. As you study more companies, you’ll find that different industries have a unique financial signature. For example, you would expect a pharmaceutical company to have very high gross margins, accompanied by very high R&D expenses. If you found a pharmaceutical company that deviated from this pattern, it should trigger a bunch of questions about how the company is being run.

Common size statements are also helpful in seeing how a company is changing over time. Are margins rising or falling? What is driving those changes?

Measuring change

Speaking of change, to become truly fluent in the language of business, you must learn how to translate changes that you see on a financial statement into plain English.

When we are looking at the change in a unit, such as revenue, net income, or green and orange plaid scarves sold, we measure change in terms of percentage growth. For example, if revenues grow from $100 million to $120 million, the change would be represented as 20% growth. The formula is below:

Percentage Growth=Period 2Period 1Period 1Percentage Growth=Period 2Period 1Period 1

By contrast, when we are looking at the change in a ratio, such as gross margin or net margin, we measure the change in terms of absolute growth. For example, if a company’s gross margins went from 30% to 35%, we would say, “margins grew by 5 points.” Typically we measure these types of changes in something called basis points. Each basis point is 1/100th of a point. Therefore, amending the prior statement, we would say, “margins expanded by 500 basis points.” The general formula for this is below:

Absolute Change=% in Period 2% in Period 1Absolute Change=% in Period 2% in Period 1

Facebook: a real-life example

Let’s apply this cool new set of tools to a company with which we’re sure you are familiar. Figure 4 is the summary income statement for Facebook, Inc., the largest social network in the world. Facebook has nearly 1.2 billion daily active users6, yet its users pay nothing to use the service. Rather they post news about themselves, along with a surprising amount of cat videos. Facebook generates nearly all of its revenue from advertisers who are trying to influence the behavior of those 1.2 billion users. Let’s look at its income statements from 2014 and 2015 to see how well this is working. Note that we’ve added in the common size statements for you (aren’t we nice?).

Figure 4
Summary Income Statements for Facebook, Inc.
$ In Millions Year Ended Dec. 31, 2015 2015 % of Revenue Year Ended Dec. 31, 2014 2014 % of Revenue
Revenue $ 17,928 100.0% $ 12,466 100%
 Cost of revenue 2,867 16.0% 2,153 17.3%
Gross Profit 15,061 84.0% 10,313 82.7%
Operating Expenses        
 R&D 4,816 26.9% 2,666 21.4%
 Marketing and sales 2,725 15.2% 1,680 13.5%
 General and administrative 1,295 7.2% 973 7.8%
Income from operations (EBIT) 6,225 34.7% 4,994 40.1%
 Interest and other income/(expense), net (31) 0.2% (84) 0.7%
 Provision for income taxes 2,506 14.0% 1,970 15.8%
Net income $ 3,669 20.5% $ 2,925 23.5%

First we can see that Facebook is showing strong growth. Revenue grew 44%, which is particularly impressive given the size of the company. We can also see that gross margins are very high—84% in 2015. This makes sense, as Facebook’s only significant input costs are those related to running its massive network. How much did gross margins change year over year?7

Let’s take a closer look at operating expenses. We can see that spending on R&D jumped significantly from 2014 to 2015, $2.7 billion to $4.8 billion. Furthermore, the percentage of revenue spent on R&D went from 21.4% to 26.9%. This major increase contributed to a significant decline in EBIT margin and net margin. Was this increase justified? That’s a great question. If you read management’s statements to the financial press, you’ll learn that in 2015 Facebook made enormous investments to build advertising products for the mobile phone environment. Management made this decision as it saw most of its customers migrate from using their computers to access Facebook to using their mobile phones.

It seems that this investment is paying off as Facebook is now generating the majority of its revenue from mobile advertising.


Congratulations! You’ve taken the first step into a large world. When you look around, you should start to think in a different way about the products you buy and the services you use. Behind each product or service is a company making decisions about how to get you to pay the most for that product, while spending the least to create it. That company will be competing with others that are pursuing different business models but with the same goals in mind.

Whether you become an analyst of these companies, an employee, or an owner, you will find this mindset to be extremely useful in helping you draw your own conclusions about the business. Over the coming chapters, we will take a deeper dive into the financial statements to see how they weave together into a highly accurate and informative picture of a company’s health. Then, we will learn how investors and managers assign a value to the company. Finally, we will see how that company fits into a broader context called “the capital markets.”

Chapter Final Exercise: How is this company doing?

Below are the income statements for a sporting goods retailer for 2013 and 2014. Using the techniques developed in this chapter, answer the following questions:

  1. How is the company doing?
  2. What action is the management team taking in reaction to its performance?

You might find it helpful to fill in the table below the income statement.

Table 3
  2013 2014
Net Revenue $ 120,000,000 $ 132,000,000
 Less: Cost of Goods Sold 82,800,000 93,060,000
Gross Profit 37,200,000 38,940,000
 Less: Selling, General, & Administrative 23,400,000 22,440,000
Operating Profit 13,800,000 16,500,000
 Less: Interest Expense 1,500,000 1,300,000
Earnings Before Taxes 12,300,000 15,200,000
 Less: Taxes 4,182,000 5,168,000
Net Income $ 8,118,000 $ 10,032,000
Revenue Growth NA  
Gross Profit Margin    
SG&A as a Percent of Revenue    
Operating Profit Margin    
Pretax Margin    
Net Margin    


Concept Check 1: Understanding Gross Margin

Exercise 1

Q. Which type of company would have higher gross margins, a supermarket or a restaurant? Why?


A. Supermarkets sell finished products to customers. By contrast, restaurants take raw ingredients and transform them into meals for their customers. The restaurant adds much more value to its inputs and will have higher gross margins. A typical restaurant has gross margins in the 60%–70% range while a supermarket might have gross margins in the 15%–25% range.

Concept Check 2: Understanding The Matching Principle

Exercise 2

Q. When you subscribe to a magazine, you typically pay up-front for it. As the publisher of the magazine, when would you recognize the revenue for that sale, and how would you treat the cash you received for the subscription in advance?


A. The matching principle tells us that revenue and expenses must be matched to the period in which they happen. The magazine recognizes revenue when it ships the issue. However, it has received cash in advance for the subscription. Even though the magazine has the cash, it can’t recognize that revenue until the publication date. The cash goes into a special place on the balance sheet called deferred revenue, which is cash received for a product or service that has not yet been delivered. When the magazine ships the issue, the dollar amount related to that issue “moves” from the balance sheet to the income statement as recognized revenue. If this is confusing now, it will make a lot more sense once we’ve worked our way through the balance sheet.

Chapter Final Exercise: How is this company doing?

In order to determine how the company is doing, we need to calculate revenue growth, as well as the common size ratios of gross margin, SG&A as a percent of sales, operating profit margin, pre-tax margin, and net margin. When you fill in the table, you will see the following:

Table 4
  2013 2014
Revenue Growth NA 10%
Gross Profit Margin 31.0% 29.5%
SG&A as a Percent of Revenue 19.5% 17.0%
Operating Profit Margin 11.5% 12.5%
Pre-tax Margin 10.3% 11.5%
Net Margin 6.8% 7.6%

This analysis reveals that gross margins have fallen year over year. We can speculate as to why this happened—there could be pricing pressure, a change in the product mix, commodity price increases, etc. What did management do about this? We can see that SG&A as a percent of sales fell, which implies that management made changes to the business in the face of falling gross margins. They might have “right-sized” (i.e., fired people), reduced advertising, or cut other overhead. Therefore, management’s actions allowed the business to increase its profit margin despite a falling gross margin.


  1. 1 See Madoff, Bernie.

  2. 2 Because of some arcane accounting rules, there are certain times you can actually hide R&D from the income statement by “capitalizing” it, or putting it on the balance sheet. This is usually a red flag that indicates a company is trying to hide something by artificially inflating profits. The best practice is to expense R&D when incurred.

  3. 3 Yet another reason why the cash flow statement is so helpful.

  4. 4 We will assume that most of you live in an area where Generally Accepted Accounting Principles, or GAAP, prevail. Other systems, such as International Financial Reporting Standards, or IFRS, which is used in Europe, have similar rules but they are implemented slightly differently.

  5. 5 This assumes simple straight line depreciation. There are other, more complex, methods of depreciation that companies can use. Aren’t you glad this isn’t an accounting course?

  6. 6 As of October 2016.

  7. 7 If you said that they expanded by 130 basis points, give yourself a gold star and go watch a funny cat video.


Business Model:
Represents a set of decisions that a company makes that determine how a company generates cash including how it generates revenue, produces its product or service, allocates operating expenses, and finances its business.
The amount earned by a firm from selling goods or providing services. Revenue is recognized at the time the good changes hands or the service is delivered to the customer.
Operating Expenses:
All of the costs of running the business including selling costs, research and development, and overhead costs such as rent and insurance.
Cost of Goods Sold:
The cost of all labor and materials that go into producing a product or delivering a service.
Gross Profit:
Revenue less cost of goods sold. Also a measure of how much a customer is willing to pay for the work that a company does to produce the product.
Gross Margin:
Gross profit divided by revenue. A measure of how much gross profit is generated per dollar of sales.
Operating Income:
The dollar amount left after subtracting operating expenses from gross profit. A measure of how much operating profit is generated per dollar of sales.
Earnings before interest and taxes. Another name for operating profit.
Pre-tax profit:
What is left from operating profit after deducting interest expense and making any other adjustments.
Net Income:
What is left after deducting taxes from pre-tax profit. Also what is available to pay shareholders and reinvest in the company. Because of distortions in the accounting system, net income is not cash.
Net Margin:
Net income divided by revenue. A measure of how much net income is generated per dollar of sales.
The Matching Principle:
The accounting rule that expenses are only recognized when the associated sale takes place, and expenses should be recognized in the period that they are incurred.
The process of apportioning the cost of an asset over the period that it will be used.
Common Size Income Statement:
A version of a financial statement in which you divide each number by the amount of revenue in that year.
Percentage growth:
The relative change in a number over two periods, calculated by dividing the change in a number between two periods by the amount in the initial period.
Absolute growth:
The actual change in a number, such as a ratio, between two periods, calculated by subtracting the final period amount from the initial period amount.
Basis point:
One hundredth of a percentage point; a way to measure the absolute change in a ratio.

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