In the previous post, I gave an overview of what financial statement is and how the 3 key financial statements (i.e. Income Statement, Balance Sheet and Cash Flow Statement) inter-relates. In this post, I’m going to focus solely on Income Statement by showing you how an Income Statement is prepared using Café as an example. I will also be discussing some of the listed companies’ Income Statement so that you’ll get a better understanding. Let’s begin.
Imagine you owned a café business selling coffee and pastries. How would your Income Statement look like? Let’s run down each element in the Income Statement as discussed in my previous post:
Since you are in a café business, your products would be coffee and pastries. Hence, your business model is simply to take customer’s order, make the beverages as ordered and sell.
Under expenses (ingredients needed to make coffee), you can classify it into 2 categories:
The first category is Cost of Goods Sold (“COGS”). This refers to the costs incurred to produce the finished products, usually it is the material used. In the case a café business, the COGS would be the coffee beans, fresh milk & pastries ingredients (i.e. flour, eggs, fruits, etc.).
However, you must know that some companies may prefer to outsource the process of making the finish products to outside vendors. In the case of a café business, its pastries can be out sourced to bakery shop and they would charge based on number of orders received and supplied.
The second category of expenses would be the Selling, General & Admin Expenses, in short, it is called “SGA Expenses”. The selling expenses refer to all costs incurred with regards to selling the company’s products/ services. This includes advertisement, phone charges, postal charges, etc. The general & admin expenses on the hand, refers to the operating expenses other than those directly related to the finish products. This includes utilities, rental, salaries, depreciation, etc.
In the case of café business, the SGA expenses would include employees’ salary, rental of the café shop, utilities and depreciation of assets such as the coffee machine.
Interest & Taxation
Of course, there are other expenses such as interest payment on loan as well as tax payment on operating profit generated. But for simplicity sake, let’s assume that your café business will incur RM3,000 of interest payment on bank borrowings and tax rate of 20% on operating profit generated for the period.
Combining it all together
When combine the revenue, COGS, SGA expenses, interest and taxation, the Income Statement of the café business would look like the following:
The above is a very simple Income Statement to ease your understanding. In actual fact, some listed companies’ Income Statement may be difficult to read. For example, below is an extract of a company’s Income Statement, Lingkaran Trans Kota Holdings Berhad (“LITRAK”):
Some company’s Income Statement like LITRAK may not show COGS (see diagram above). Thus, it does not show what the Gross Profit is for Litrak. But in order to understand why its Income Statement is presented in such a way, you must understand the industry Litrak is in. This company is involved in the management of toll operation in Malaysia. The most notable ones are LDP and Sprint highway. Such business model does not allow expenses to be clearly classified into either COGS or SGA Expenses.
Under such circumstances, I will always use my own judgments. Since toll operation is their business model, any costs incurred that are directly attributable to managing the toll operation would be classify as COGS. This means that maintenance and employee benefit expenses would be LITRAK’s COGS because you need to incur costs to maintain the highway road and you need employee to collect the concessions.
Another company that has the similar Income Statement would be IQ Group Holdings Bhd. Here is an extract of its Income Statement:
In IQ-Group’s case, the company is involved in designing, manufacturing and sale of smart lighting solutions. Once you understand what the company does, you should be able to identify that the COGS is the changes in inventories of finished goods & work-in-progress, raw materials and consumables used as well as the purchase of trading goods since these costs are directly attributable to its finished goods sold.
The Income Statement provides us an overview of a company’s business performance whether it is profitable or loss making. You do not want to invest in companies that have loss making businesses. That’s why it is crucial to study the Income Statement of a company. I hope by showing you the above two listed company’s Income Statement, you now know how to read Income Statement. My next post will be on Balance Sheet and we are going to use the same example which is the café business to ease your understanding. I hope you learn something by reading this article!
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