The Income Statement
With the balance sheet providing a snapshot of financial position, the income statement tells you how the company actually performed over a period: whether it made or lost money.
Income Statement Structure
The income statement follows a top-down flow from revenue to net income. Each line subtracts a category of expenses:
Revenue (Sales)
- Cost of Goods Sold (COGS)
= Gross Profit
- Operating Expenses (Selling, General & Administrative, depreciation)
= Operating Income (EBIT)
- Interest Expense
= Earnings Before Taxes (EBT)
- Income Taxes
= Net Income (Net Profit)
- Revenue (the "top line") - total sales before any deductions
- Net income (the "bottom line") - what remains after all expenses
Exam Tip: Gotchas
- "Top line" = revenue; "bottom line" = net income. The exam uses these terms interchangeably with the formal names.
Key Profitability Measures
| Measure | Formula | What It Shows |
|---|---|---|
| EBITDA | Net income + Interest + Taxes + Depreciation + Amortization | Operating cash flow proxy; removes effects of financing and accounting decisions |
| EBIT (Operating Income) | Revenue - COGS - Operating expenses | Operating profitability before financing costs |
| EBT | EBIT - Interest expense | Pre-tax profitability |
| Net income | Revenue - All expenses (including taxes) | Bottom-line profitability |
- EBITDA is useful for comparing companies with different capital structures and depreciation policies
- EBIT isolates the core business performance from financing decisions
- Moving down the income statement, each measure includes more expense categories
Exam Tip: Gotchas
- EBITDA adds back depreciation and amortization to approximate operating cash flow, but it is NOT actual cash flow from operations.
- Interest expense comes AFTER operating income (EBIT) - it is a financing cost, not an operating cost.
Earnings Per Share (EPS)
EPS is one of the most widely followed metrics for evaluating a company's profitability on a per-share basis.
Basic EPS
- Basic EPS = Net income / Weighted average shares outstanding
- Uses only shares that are currently issued and outstanding
Fully Diluted EPS
- Fully diluted EPS = Net income / (Shares outstanding + All potentially dilutive securities)
- Dilutive securities include:
- Convertible bonds
- Convertible preferred stock
- Stock options
- Warrants
- Fully diluted EPS is always equal to or lower than basic EPS (more shares in the denominator)
- Gives the worst-case (most conservative) EPS figure
Exam Tip: Gotchas
- Fully diluted EPS assumes ALL convertible securities and options are exercised. This gives the lowest possible EPS figure.
- The exam may ask which securities dilute EPS - the answer includes convertible bonds, convertible preferred, options, and warrants.
- If a question asks for the "most conservative" EPS measure, it wants fully diluted.
- Fully diluted EPS can never be HIGHER than basic EPS - it can only be equal or lower.