Selling, General and Administrative expense (SG&A)

R&D expense (if any)

Revenue

To better understand income statement, think of it as a typical American family. Let us assume a hypothetical household comprises of four members: Father Todd, Mother Jane, and son Paul and Shawn. What is its revenue? Most likely it is the salary generated by either mom or dad. Without source of revenue, companies sooner or later will be unable to cover the cost of living. Jane works as a secretary earning $25,000/ year while Todd works as a store manager earning $30,000/year. Their combined revenue is the revenue for the household which is $55,000/year.

COGS or Cost of Service Sold

Since both Todd and Jane are working, instead of COGS, they will incur Cost of Service sold.  In this case, what does it cost both Jane and Todd to provide their labor to their respective employers? Variable costs are normally assigned as Cost of Service Sold while fixed cost falls into SG& A expense. Most of the household’s expense can be considered fixed. Therefore, Cost of Service Sold is $0.

Gross Profit

Gross Profit is the profit left after subtracting Cost of Service from Revenue. Since Cost of Service is $0, Gross profit for this household is $55,000/year.

Selling, General and Administrative expense (SG&A)

These are the fixed expenses that a family incurs. It includes meal, transportation, housing, clothing, electricity and entertainment. Overall, the family spends $10,000 on food, $5000 on car payment, $18,000 on mortgage, $ $3000 on clothing, $2000 on electricity and $ 6000 on entertainment. Total SG&A for the year is $44,000

R&D expense (if any)

This is the expense incurred for additional future revenue. For example, Todd is currently enrolling in night school to obtain his MBA in expectation of higher salary. His school fee for the year costs $10,000/year.

Operating Profit

The total money left after subtracting all these expenses are called operating profit. For this household, operating profit is $10,000/year.

Interest income/expense

This family has a combined savings account of $5,000 earning 1% a year while incurring $15,000 in credit card debt with interest rate of 15% annually. Total interest expense for the family is $2200/year

Net Income before tax

Subtracting Interest income from operating profit will give the net income before tax for Father Todd’s family. The number for this household is $7800/year.

Income Tax

Assume a tax rate of 25%, Todd pays income tax of $1950 for his family. (In reality, individuals like Todd and Jane normally pay tax first before they can deduct other expenses. However, this example is for illustrative purpose only)

Net Income

 What is left after paying income tax is net income. In this case, the family netted a $5850 per year.

Number of Shares Outstanding

A typical family does not have shares outstanding. Therefore, we will just explain this as it is. If the bookstore around the corner is valued at $1,000,000 while the stock is traded at $10/share, the bookstore has 100,000 shares outstanding. This figure is important to know because when buying stocks, we are not buying the whole company. Instead we are buying the company share per share basis. Therefore, shares outstanding will be important to get the value of Earning per share, Book value per share, Cash per share, and so forth.

Earning Per Share

Suppose you are buying Microsoft shares for $25 a share. What is the company’s net income? The latest net income is $ 8 Billion. Does it help? Kind of. For this information to be useful, we need to compare it with the per-share figure. The number of shares outstanding for Microsoft is 10.8 billion shares. Earning per share is the company’s net income divided by the number of shares outstanding which is $0.74/share.

Now, we get a sense on how you buy in relation to profit. For every $25 of Microsoft stock that you buy, the company is able to squeeze out a profit of $0.74. However, it is critical to be able to predict how much earning per share a company will make in the future. Let’s roll to pro-forma income statement. What do you think?