The Income Statement

The income statement is, along with the balance sheet and the cash flow statement, one of the important financial statements that a company releases. It is the focus of much analysis and speculation. It's not as difficult to understand as the balance sheet and the cash flow statement, but in some ways it is a more slippery fish to grasp. This is because of the discretion management has in deciding what revenue and expenses to recognize each year.

An income statement is pretty simple. It shows the revenue for the year and then deducts all the expenses to show the company's net income. Let's look at Microsoft's income statement for 2015.

This page from Microsoft's online annual report says "Income Statements" rather than "Income Statement." That just means they are showing you three years of statements side by side. This allows you to see the changes from year to year. The most recently completed year, 2015, is shown first. (The 2016 statements for Microsoft should be out soon, but I'm not willing to wait.)

Breaking it down

Let's look at the various sections of the income statement in more detail.

The first section shows the calculation of the gross margin:

  • Revenue is the sales of all products and services recorded during the year. This is not the same as the cash the company received for those sales, but it's usually close. If a company sells something to a business customer and they are still waiting for the customer to pay, they'll usually record the sale even if they haven't received the money. But this generally evens out from year to year, because the company probably received cash at the beginning of the year for sales it recorded at the end of the previous year.
  • Cost of revenue includes all the expenses that can be tracked directly to products and services sold. You'll notice that for Microsoft, the cost of sales ($33 billion) is only about one third of the revenue ($93 billion). This is typical for a company that sells a lot of software and services, because it doesn't cost a lot of money to produce one more copy of Microsoft Office, for instance. For a company that produces mainly physical things like automobiles, such as Ford or Volkswagen, the cost of sales is going to be a lot higher, proportionally.
  • Gross margin is simply what's left after deducting the cost of sales from the revenue. This is what the company has available to pay for other things like the salaries of corporate executives or the pension plans offered to its employees.

We'll look at Microsoft's actual numbers in more detail in the next article, but for now, you can see that Microsoft's revenues grew steadily from 2013 to 2015, from $77.8 billion to over $93.5 billion, but the cost of all that revenue grew just as much. The gross margin, therefore, hardly changed at all over the three years, moving from $57.5 billion to $60.5 billion. That's "just" a three billion dollar increase.

The next section shows all the other expenses of the company related to its operations, over and above the cost of the sales shown in the first section. Companies vary quite a bit in the amount of detail they show here, and how they break things down into categories.

For Microsoft, the operating expenses shown are:

  • Research and development, which is what they spent trying to come up with new ways to make money,
  • Sales and marketing, which includes things like advertising,
  • General and administrative, which includes corporate salaries, and
  • Impairment, integration, and restructuring, which I think deserves more attention so I will make it the focus of my next article.

The remaining items, besides the subtotals and totals, are:

  • Other income, net, which is where Microsoft shows the net of its financing revenue and expenses. All the interest and dividends it received on any financial investments are netted against the interest it paid on any debt, and against any gains or losses on financial instruments that it owned. If you are interested in seeing this in more detail, you can check out Note 3 to its financial statements.
  • Provision for income taxes, which is the amount that Microsoft expects to pay on the income that it recognized this year. Some companies just say "income tax expense," but by saying "provision," Microsoft is just making it clear to the reader that the income tax expense shown here might is not the same as the amount remitted to the governments of the countries where it did business. Some of this might have been paid already, and some of it might not be paid until next year or even later. This is because income tax regulations in each country differ from the accounting regulations that Microsoft must follow.

Everything else shown is subtotals and totals, starting with the gross margin mentioned above, then the operating income, the income before taxes, and finally the net income. Net income for 2015 was kind of a let-down.

You can see that the "Impairment, integration, and restructuring" item is the only operating expense that changed dramatically over the three years shown. It accounts for almost all the change in net income. To understand why Microsoft experienced a big drop in net income in 2015, you have to understand this expense.

Stay tuned!

Photos of the Peterborough and Kirkfield lift locks taken in July and August 2016. They are the highest and second highest hydraulic lift locks in the world. There are higher lift locks in Belgium and China now, but I am reliably informed (Wikipedia!) that they operate on different principles.

Photo of Burleigh Falls taken in August 2016.