What you need
- The company's latest 10-K and the two most recent 10-Qs, free on SEC EDGAR. Our explainer on what a 10-K contains shows where the statements sit.
- The latest earnings release, for management's own summary and any non-GAAP figures.
- The balance sheet and cash flow statement from the same filings, for cross-checks.
- A spreadsheet or notebook to put three years of figures side by side.
Step 1: Learn the layout
US companies present the income statement in a standard order, though line names vary.
| Line | What it shows | Key question |
|---|---|---|
| Revenue | Sales for the period | Is it growing, and why? |
| Cost of revenue | Direct costs of what was sold | Are costs rising faster than sales? |
| Gross profit | Revenue minus cost of revenue | What share of each sale is kept? |
| Operating expenses | SG&A, R&D, depreciation and amortization, other | Are overheads growing in line with revenue? |
| Operating income | Gross profit minus operating expenses | Is the core business profitable? |
| Interest and other income or expense | Financing costs, gains, losses | What is not from operations? |
| Pre-tax income | Operating income plus non-operating items | |
| Income tax | Tax expense for the period | Is the rate normal? |
| Net income | Profit after everything | |
| EPS (basic and diluted) | Net income per share | How did the share count change? |
Most companies show three years in the 10-K and the current and prior-year quarter in the 10-Q. Always compare like with like.
Step 2: Start with revenue
Revenue is the first line for a reason: nothing else grows for long without it.
- Calculate growth over the prior year and, for quarterly figures, against the same quarter a year earlier to avoid seasonal effects.
- Read the segment note and the MD&A to see where growth came from: volume, price, new products, acquisitions or currency.
- Separate organic growth from acquired growth. A company that bought a competitor can show strong revenue growth while its original business shrinks.
Step 3: Check gross margin
Gross margin is gross profit divided by revenue. It shows how much of each dollar of sales is left after the direct costs of producing what was sold.
A stable or rising gross margin usually means pricing power or efficient production. A falling one can mean discounting, higher input costs or a shift toward lower-margin products. Compare it over several years and against peers, because what counts as normal differs widely by industry.
Step 4: Read operating expenses and operating income
Operating expenses are the costs of running the business that are not tied directly to each sale: selling, general and administrative (SG&A), research and development (R&D), and depreciation and amortization if shown separately.
Calculate each as a percentage of revenue and watch the trend. If revenue grows 10% and SG&A grows 4%, the company is gaining operating leverage. If expenses grow faster than revenue, margins will shrink.
Operating income, sometimes called EBIT, is the best single line for judging the core business. Operating margin, operating income divided by revenue, lets you compare across years and companies.
Watch for these inside operating expenses:
- Restructuring charges, which companies often ask you to ignore. If they appear every year, they are a cost of doing business.
- Impairments of goodwill or other assets. These are non-cash and often one-time, but they record that an earlier investment lost value. Our explainer on goodwill and impairments covers how to read them.
- Stock-based compensation, which is spread across the expense lines. Whether to treat it as a real cost is covered in is stock-based compensation a real expense.
Step 5: Read below the operating line
Everything between operating income and pre-tax income comes from outside the core business.
- Interest expense. Compare it with operating income. The ratio is the interest coverage ratio, a quick test of debt risk.
- Interest income. Large for companies with big cash balances, and sensitive to interest rates.
- Gains and losses on asset sales, investments, debt extinguishment or currency. These can be large and rarely repeat.
- Equity-method income from stakes in other companies.
Step 6: Check taxes and net income
Divide income tax by pre-tax income to get the effective tax rate. Compare it with the statutory rate and the company's history. A sudden drop may come from a one-time benefit, such as the release of a valuation allowance on deferred tax assets, that will not repeat.
Net income is what remains. If it moved very differently from operating income, the explanation is in Steps 5 and 6.
Step 7: Read the share count and EPS
EPS is net income available to common shareholders divided by weighted average shares. Two versions appear:
- Basic EPS, using shares outstanding.
- Diluted EPS, adding shares from options, warrants, convertible securities and similar instruments.
Check the weighted share count over several years. Buybacks lift EPS without any change in profit; share issuance and dilution lower it. If EPS grew 12% while net income grew 4%, most of the improvement came from fewer shares.
Step 8: Compare GAAP with adjusted figures and cash flow
Most companies also report adjusted or non-GAAP figures in their earnings release. These remove items management considers unusual. Read the reconciliation, which SEC rules require, and decide for yourself which adjustments are fair. Our explainer on adjusted EBITDA covers the common ones, and normalized earnings covers how to build your own view of a typical year.
Then compare net income with cash from operations on the cash flow statement. Over several years, the two should move together. Profit that consistently runs ahead of cash is a warning sign, often pointing to rising receivables or inventory on the balance sheet.
Step 9: Read the footnotes behind the big numbers
The footnotes explain the policies and judgments behind each line: when revenue is recognized, how inventory is costed, what is inside "other income" and how segments perform. Our guide on reading the footnotes in a 10-K shows where to find each one.
For services that help with this work, see our list of the best stock research tools for individual investors. Dombey's published research reads each income statement this way before a catalyst; see the research archive.
Common mistakes
- Starting at the bottom. Net income and EPS are the most quoted numbers and the most distorted. Read from the top.
- Comparing the wrong periods. Comparing a holiday quarter with the one before it says little; compare with the same quarter a year earlier.
- Taking "one-time" at face value. Charges that recur every year are part of the cost base.
- Ignoring the share count. EPS growth can come entirely from buybacks.
- Trusting adjusted figures without reading the reconciliation. Some adjustments are reasonable; others remove real costs.
- Skipping the cash flow statement. Profit without cash is the most common sign of aggressive accounting.
The bottom line
Read an income statement from the top: revenue growth, gross margin, operating expenses and operating income tell you how the business is doing. Then work down through interest, gains, taxes and the share count to see what changed net income and EPS for other reasons. Cross-check every result against cash flow and the footnotes. A company whose operating income, cash flow and net income tell the same story is easier to trust than one where they diverge.