Many see the income statement as just a list of numbers, but not you. The income statement tells a detailed story of a company’s operational success, cost efficiencies and profitability – you only need to know where to look.
This article is your guide to decoding that story using the metrics and analysis methods employed by the pros…
So, you can become one, too 😉
This is the second article in our Income Statement Series. Expand here for the others.
Types of Income Statement Analysis
Numbers on the income statement are just that – numbers. They have no meaning on their own, and that’s the reason investors and analysts use various analysis methods.
Each method provides behind-the-scenes insight into a company’s financial performance, so here are the main ones.
Ratio Analysis
Ratio analysis (or metric analysis) transforms a company’s reported numbers into meaningful performance indicators by standardising performance into comparable profitability and efficiency ratios.
Ratio analysis highlights (1) the drivers of company performance and (2) its strengths and weaknesses in profitability. Investors and management teams also use ratios to support investment and operational decisions.
Horizontal Analysis
This form of analysis compares figures and ratios over several financial periods to identify trends, possible growth trajectories and potential red flags. To do so, horizontal analysis calculates absolute (money-based) and percentage changes in revenue, expenses and profits.
For example, if Example Industries reported revenues of £500,000 and £700,000 in 2023 and 2024, respectively:
- Absolute Change = £200,000 (700k – 500k)
- Percentage Change = 40% (700k ÷ 500k – 1)
Horizontal analysis is sometimes called trend analysis because it shows how line items have evolved with time.
Vertical Analysis
Vertical analysis (or margin analysis) expresses income statement items as a percentage of revenue, making it easier to compare across financial periods. It highlights a company’s profitability and cost efficiency and can be used to compare companies with similar operations, regardless of size.
To highlight (and compare) profitability, let’s say Example Industries has an 80% gross margin, while Sample Co’s gross margin is 40%. Based on that margin alone, Example Industries is more profitable – it retains a higher percentage of revenue (80% versus 40%).
Cost efficiency reveals the percentage of revenue a company spends on expenses. In the example above, Example Industries spends 20% (1 – 80%) of its revenue on covering the costs of making the products it sells, while Sample Co spends triple that at 60% (1 – 40%). Therefore, Example Industries is the more cost-efficient of the two.
Profit and cost efficiency margins will make more sense in the next section.
Income Statement Metrics & What They Reveal
Each income statement line item has a ratio, a growth component (horizontal analysis), and a margin component (vertical analysis). Together, these give a company’s income statement meaning.
Here are the most common metrics investors and analysts use to read and interpret income statements.
(This section pairs well with the “Structure & Components” section in this article.)
Growth Metrics (Horizontal Analysis)
Revenue Growth: Indicates business expansion, pricing power and customer demand.
Revenue Growth = (Current Revenue ÷ Prior Revenue) – 1
Net Profit Growth: Shows a company’s year-end or quarterly earnings trend.
Net Profit Growth = (Current Net Profit ÷ Prior Net Profit) – 1
Profitability Metrics (Vertical Analysis)
Gross Margin: Reflects the percentage of revenue retained after paying for the direct cost of making the goods and services sold.
Gross Margin = Gross Profit ÷ Revenue
Interpretation: A company with an 80% gross margin retains £80 in gross profit for every £100 of revenue generated.
Operating (EBIT) Margin: Highlights a company’s core profitability. It shows the percentage of revenue retained after deducting all direct costs and operating expenses.
Operating Margin = Operating Profit ÷ Revenue
Interpretation: A 50% operating margin means a company keeps half the revenue generated as operating profit.
Profit Before Tax (PBT) Margin: Used to compare companies with different tax rates. It highlights the percentage of revenue kept after accounting for all business costs except tax.
PBT Margin = Profit Before Tax ÷ Revenue
Interpretation: A company with a 40% profit before tax margin retains £40 in profit before tax for every £100 of revenue generated.
Net Margin: Highlights a company’s final level of profitability. It tells investors what percentage of revenue remains after covering all business expenses.
Net Margin = Net Profit ÷ Revenue
Interpretation: A 15% net margin means a company retains £15 in net profit for every £100 of revenue generated.
Expense Efficiency Metrics
SG&A Margin: Highlights the percentage of revenue spent on non-production expenses. Selling, general and administrative (SG&A) expenses comprise administrative salaries, rent and marketing costs.
SG&A Margin: SG&A Expenses ÷ Revenue
Interpretation: A 15% SG&A margin means a company spends £15 on SG&A for every £100 of revenue generated.
R&D Margin: This shows the percentage of revenue spent on research and development (R&D). R&D expenses usually relate to companies in highly innovative industries, such as technology and healthcare.
R&D Margin = R&D Expenses ÷ Revenue
Interpretation: A 10% R&D margin means a company spends £10 on R&D for every £100 of revenue generated.
Interpreting Google’s Income Statement (+ 2 FREE Resources!)
Formulas are fun (maybe not), but real-world application makes everything stick. So, we’ve created two FREE resources for you:
- A Spreadsheet File: An Excel/Google Sheets walkthrough (with step-by-step videos) of interpreting five years of Google’s income statements.
- An Infographic: A cheat sheet with the metrics you need for the income statement.
📥 Up for some practice and hands-on experience? Analyse and interpret five years of Google’s income statements here.
Income Statement Red Flags
Reading and interpreting an income statement is equally about understanding financial performance and identifying issues.
Here are some red flags to look out for.
- Revenue growth, no profit growth: May suggest margin contraction due to rising business costs.
- Net profit inflated by non-operating income: Non-recurring gains may mask poor performance from the company’s core business.
- Frequent “one-off” expenses: Maybe they aren’t one-offs?
- Sharp swings in margins or efficiency ratios: These could point to unstable operations or hidden inefficiencies.
Digging into red flags can reveal plenty about a company and its direction.
Tips For Holistic Interpretation
Assessing a company based on one statement is never a good idea. One statement can’t answer all your possible questions.
So, to get a more complete picture of a company:
- Cross-reference with the cash flow statement and balance sheet to verify earnings quality and asset efficiency.
- Compare with industry peers to assess competitive standing.
- Don’t analyse metrics in isolation. Use them as part of a broader narrative.
- Read the Notes to Financial Statements to get more context on the numbers.
A complete analysis is the best analysis.
Rounding It All Up!
Reading and interpreting an income statement uncovers the story behind the numbers. From understanding profitability to evaluating ratios, income statement analysis helps build a comprehensive picture of a company’s operational performance and financial trajectory.
Mastering this skill empowers informed decisions, whether you’re an investor, finance student or aspiring analyst. The more you practice interpreting these figures in context, the sharper your analytical intuition will become.
So don’t just read the numbers – listen to what they say about a business.
