Definition and Example of Income Statement Formulas
Income statement formulas are calculations that you can make by using the information from a company's income statement. As you work through analyzing a company's financial statements, income statement formulas can provide valuable insight into a company's financial performance, including revenue, operating expenses, cost of debt, and profitability.
These formulas can help you be a more effective investor by allowing you to measure a company's:
Although we delve into the formulas in more detail below, let's consider an example in which an investor wants to measure how much profit margin a company generated for each dollar of revenue earned from sales. We would divide the company's revenue by profit using the net profit margin formula.
If the company had $1,000,000 in revenue and $200,000 in profit, its net profit margin would be 20%, because ($1,000,000 revenue / $200,000 profit = .20 * 100). We multiply the resulting decimal in the formula by 100 to convert it to a percentage. In other words, the company earned 20 cents per dollar.
It can help to break down financial ratios into five different categories. Grouping together the ratios helps you keep the bigger picture in mind, and how the various components fit into that bigger picture.
Common Income Statement Formulas
A company's income statement contains a significant amount of information, all of which can tell you important information about your investment. Using the correct income statement formula will allow you to analyze this information.
As an investor, it helps to familiarize yourself with the common income statement formulas and what they can tell you.
Gross Profit Margin
To calculate gross profit margin, divide gross profit (revenue minus sales) by total revenue.
Research and Development to Sales
Research and development, or R&D, costs are expenses listed on an income statement. They tell you how much the company spends per year on developing new products or services.
The R&D-to-sales formula tells you the relationship between R&D and the income that a company is bringing in. It is calculated by dividing R&D expenses by revenue.
Operating margin, also known as "operating profit margin," is a measure of efficiency.
A company's operating profit is how much profit remains after deducting all expenses. However, operating profit can vary widely due to differences in business models, expenses, and other factors.
The operating margin allows you to compare a company's financial activity to that of its competitors by creating a percentage relative to revenue. It is calculated by dividing operating income by revenue.
Interest Coverage Ratio
The interest coverage ratio is important when you are dealing with banking, insurance, real estate, or other investment companies.
This ratio compares the earnings before interest and taxes (EBIT) to interest expense, which are listed as a separate item on the income sheet. This shows you how much a company is relying on borrowing to fuel its growth or to fund operations.
Calculate the interest coverage ratio by dividing earnings before interest and taxes by interest expenses.
Net Profit Margin
Net profit margin is the ratio of net income (or after-tax profits) to revenue. It tells you what percentage of every dollar collected actually translates into profit for a company.
It is calculated by dividing net income by revenue.
Return on Equity
Return on equity (or ROE) is one of the most important measures of profitability that investors can use. This ratio shows how much after-tax income a company earned compared to shareholder equity.
This shows how efficiently the company has been handling its money. It is calculated by dividing net profit (after-tax income) by shareholder equity.
Asset Turnover Ratio
The asset turnover ratio calculates the amount of revenue for every dollar of assets owned by the company. It measures how efficient the company is at using its assets.
What counts as a higher value is often dependent on the industry. It is calculated by dividing revenue over a period of time by the average value of assets for that same period.
Return on Assets
Calculating the return on assets tells you how well a company uses its assets to generate income. It is a measure of management and productivity.
It is generally helpful to compare this value across several time periods. Return on assets is calculated by dividing net income over a given time period by total average assets in that same time period.
Return on assets can also be calculated by multiplying net profit margin and asset turnover.
Balance Sheet and Income Statement Formulas
An income statement isn't the only tool that investors can use to learn about a company. When you analyze both an income statement and a balance sheet side-by-side, you can calculate several additional financial ratios.
Sales to Working Capital Ratio
Calculating the working capital per dollar of sales shows you how well a company uses its working capital to generate sales. This is a measure of efficiency and can be used to compare competitors in the same industry.
Working capital is the amount of money a company has available for daily operations. It is calculated by subtracting current liabilities from current assets, both of which are found on the balance sheet.
The ratio is calculated by dividing total sales by working capital.
A company's receivables turnover shows how efficiently a company collects accounts receivable. The faster this happens, the more working capital a company has to grow and pay investors.
Receivables turnover is calculated by dividing net credit sales in a select time period by the average net receivables for that same time.
Inventory Turnover Ratio
Calculating a company's inventory turnover tells you how long it takes to sell through its entire inventory. This information will give you a sense of a business's efficiency, growth potential, and ability to generate revenue.
Inventory turnover is calculated by dividing the cost of goods sold by the average inventory for a given time period.
What Income Statement Formulas Can Tell You
Income statement formulas can tell you important information about how a business functions, compared to competitors in its industry and to its own past performance.
Using these formulas can help you decide whether a company is a smart investment or a risky one, as well as whether the degree of risk is worthwhile. This can be useful information to have before making an investment or buying stock.
These formulas can also help you evaluate the performance of a company that you have already invested in, allowing you to decide whether to keep or sell a stock.
Limitations of Income Statement Formulas
While each income statement formula can tell you a great deal about a company, financial ratios are only the start. The ultimate goal is to be able to calculate something known as "owner earnings."
Popularized by Warren Buffett in the 1980s, a company's owner earnings are the net cash flow over the entire life of the business, minus dividends and other reinvestments into the business.
This metric attempts to answer the question, "If I owned this asset, how much cash could I extract from it after taking care of necessary expenses, taxes, and maintenance capital expenditures required to keep unit volume steady without harming the competitive position of the enterprise?"
When you take an owner earnings approach to income statement analysis, you need all three types of financial statements together—balance sheet, income statement, and cash flow statements—as well as the ability to discount cash flows to come up with a net present value.
Income statement formulas are also limited in that they only look at the finances of a single company or, at best, can be used to compare multiple companies to each other. They don't tell you anything about outside factors that can influence your investing decisions, such as:
- International trade developments
- Changing government regulations
- Bad press, scandals, or changes in leadership
- Overall industry health
These factors should also be taken into consideration when deciding whether a company is a wise or risky investment for your portfolio.