Quantitative Methods of Evaluating Businesses and Investments - The Income Statement: Key Calculations

When evaluating companies, checking their financial statements is a good place to start. For the Series 65 exam, you should be able to identify components of the income statement that determine the health of a company.

The income statement allows you to compare revenues to expenses, among other items. The following key calculations allow an IA to determine if a company is profiting from its own operations, what its net income is, and the amount of cash a company generates and uses in a period. We will discuss each in more detail below.

7.1: Operating income = Gross income - (operating expenses + depreciation)
7.2: EBIT = Revenue - operating expenses
(EBIT: Earnings Before Interest and Taxes)
7.3: Net income = Total income - depreciation, interest, tax liabilities and other expenses.
7.4: Cash flow = Net income + depreciation +/- other charges to income

Formula 7.1:
Operating income does not include things such as investments in other firms, taxes, interest expenses or nonrecurring items, such as cash paid in a lawsuit settlement. Operating income is also known as operating profit or recurring profit. Gross profit is often referred to as the gross margin of a company, and operating expenses are often referred to as thecost of goods sold (COGS).

Essentially, operating income represents income received from core operations, minus the cost of day-to-day functions and the loss accumulated on tangible assets. Operating income is important for investors because it shows if a company's working base is profitable. A low operating income can raise questions over whether too much is being spent on marketing or salaries, or whether the equipment is being misused, resulting in a higher than necessary rate of depreciation.

Formula 7.2: EBIT. One of the most important figures to consider on a company's income statement, EBIT determines a company's financial performance and includes all profits (both operating and non-operating) before interest and income tax deductions.

Another EBIT measure is EBITDA, which is Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA can be used to analyze the profitability between companies and industries because it eliminates the effects of financing and accounting decisions. However, this is a not a GAAP (Generally Accepted Accounting Principles) measure in that it allows a greater amount of discretion in what is and is not included in the calculation. This also allows the company to change the terms of its calculation from one reporting period to the next.

A common misconception is that EBITDA represents cash earnings. EBITDA is a good metric to evaluate profitability, but not cash flow. Consequently, EBITDA is often used as an accounting gimmick to dress up a company's earnings. It is key that investors also focus on other performance measures to make sure the company is not trying to hide something with EBITDA.

The following article EBITDA: The Good, The Bad, And The Ugly sheds more light on this ratio.

Formula 7.3:
Net Income is a company's total earnings, or profit. Net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. This number is an important measure of how profitable the company is over a period of time. The measure is also used to calculate earnings per share.

Formula 7.4: Cash flow is essentially the amount of cash a company generates and uses during a period, calculated by adding non-cash charges (such as depreciation) to the net income after taxes. Cash flow can be used as an indication of a company's financial strength. Cash flow is crucial to companies: having ample cash on hand will ensure that creditors, employees and others can be paid on time.

The Income Statement: Key Ratios - Profit and Operating Margin
Related Articles
  1. Professionals

    Career Advice: Financial Analyst Vs. Investment Banker

    Read an in-depth comparison about working as a Financial Analyst vs. working as an Investment Banker, two highly prestigious business careers.
  2. Professionals

    Who Needs to Take the Series 65?

    Most states require individuals to pass the Series 65 exam in order to act as investment advisors.
  3. Personal Finance

    RIAs and Brokers: What's the Difference?

    RIAs and brokers are held to different standards when providing investment advice. Here's how they differ.
  4. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  5. Professionals

    Understanding Series 6

    Upon successful completion of the Series 6, an individual will have the qualifications needed to sell open end mutual funds and variable annuities
  6. Professionals

    Top Strategies on How to Become a Stock Broker

    Gunning to be a stock broker and want an edge? Here's some veteran advice.
  7. Trading Systems & Software

    Steps to Starting Up an Independent Broker Dealer

    Launching your own broker-dealer is a lot of work, but the potential payoff is great, both personally and financially.
  8. Professionals

    Understanding Series 63

    Series 63 is a securities license that entitles the holder to sell securities in a particular state.
  9. Professionals

    How To Answer Option Questions On The Series 7 Exam

    Learn how to answer option questions on the Series 7 exam. Pass your Series 7 exam with the help of these tips.
  10. Insurance

    Municipal Bond Tips For The Series 7 Exam

    Learn to distinguish between general obligation and revenue bonds to ace this test.
  1. Series 6

    A securities license entitling the holder to register as a limited ...
  2. Series 79

    A examination to ensure a candidate is qualified to become a ...
  3. Research Analyst

    A person who prepares investigative reports on equity securities. ...
  4. Series 34

    An exam required for individuals seeking to engage in off-exchange ...
  5. Financial Advisor

    One who provides financial advice or guidance to customers for ...
  6. Series 23

    An exam offered by the Financial Industry Regulatory Authority ...
  1. Is a financial advisor required to have a degree?

    Financial advisors are not required to have university degrees. However, they are required to pass certain exams administered ... Read Full Answer >>
  2. Do financial advisors have to be licensed?

    Financial advisors must possess various securities licenses in order to sell investment products. The specific products an ... Read Full Answer >>
  3. If I have only a limited amount of time to study for the Series 6, what should I ...

    The Series 6 Investment Company and Variable Contracts Products Representative Qualification Examination is administered ... Read Full Answer >>
  4. What role does the 'chip cycle' play in the electronics sector?

    There are several highly acclaimed private Series 6 Exam courses in the United States. Many can be completed online. Popular ... Read Full Answer >>
  5. What does passing the Series 6 enable me to do?

    The Series 6, or the Investment Company Products/Variable Contracts Limited Representative, exam is administered by the Financial ... Read Full Answer >>
  6. What are the differences between the Series 6 exam and the Series 7 exam?

    The Financial Industry Regulatory Authority (FINRA) offers a variety of licenses that must be obtained before conducting ... Read Full Answer >>
Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!