Latest / How Canadian Markets Work / Episode 71: The Income Statement (The Estimate of Profit)

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Episode 71: The Income Statement (The Estimate of Profit) · How Canadian Markets Work

0:00
So imagine two companies for a second. OK, I'm
0:03
picturing them. Right. So they make the exact
0:05
same product, they sell to the exact same customers,
0:07
and they pay the exact same costs for their materials.
0:11
Sounds like identical twins. Exactly. But here's
0:14
the crazy part. At the end of the year, company
0:18
A reports $18 million in profit, and company
0:22
B reports $24 million. Oh, wow. That's a huge
0:26
difference. Yeah, it is. And neither of them
0:29
is committing fraud. Both sets of books are fully
0:31
audited by professionals and they both comply
0:35
entirely with standard accounting rules. Which
0:38
just sounds impossible, right? It really does.
0:40
But whether you are prepping for a high -stakes
0:42
meeting or managing your own investments or you
0:45
just hate feeling lost when financial jargon
0:47
starts flying, today's mission is to decode exactly
0:50
how that is legally possible. That's a great
0:52
mission. Right. We're taking a deep dive into
0:55
our curated stack of financial education sources
0:57
to dissect the single most scrutinized document
1:00
in all of business. I mean, the income statement,
1:03
which is also known as the estimate of profit.
1:05
Yeah. And that word estimate is really the secret
1:07
hiding inside that two company paradox you just
1:10
brought up. Oh, yeah. Yeah, it's a core insight
1:12
from the sources that just completely shifts
1:14
how you view financial statements. Because profit
1:18
is not this hard, immutable fact. It's actually
1:21
an opinion. It's an estimate produced under a
1:24
set of rules that intentionally permit a really
1:27
wide range of management choices. So the executives
1:30
get to choose things. Exactly. They get to choose
1:32
exactly when to recognize revenue or how quickly
1:37
they want to officially declare that their factory
1:39
equipment is wearing out. OK, let's unpack this
1:41
because our sources highlight a really crucial
1:44
distinction that makes this all click. Yeah,
1:47
the photograph versus the film analogy. Right,
1:49
exactly. If you look at a company's balance sheet,
1:52
you are basically looking at a photograph. It's
1:54
just a snapshot of what they own and what they
1:57
owe at one single instant in time like, say,
2:00
midnight on December 31st. And because it is
2:03
a photograph, management can post for it. Right.
2:05
They can window address the numbers right before
2:07
the camera flashes. Yeah. But the income statement,
2:10
on the other hand, is a film. Yeah. It shows
2:12
what happened over a continuous period of time,
2:14
like a full quarter or a full year. And since
2:16
it is a motion picture of the business in operation,
2:20
someone has to direct it. Right. Someone has
2:22
to sit in the editing room and decide when the
2:24
scenes start and stop. So to watch this film
2:26
properly, we basically need to hit play from
2:29
the very beginning of the story. The top line.
2:31
Yeah. The story always starts where the money
2:32
first enters the building. Revenue. And in theory,
2:37
this sounds like the purest number on the entire
2:40
document because it just represents what the
2:42
company actually sold to its customers. What's
2:44
fascinating here is that even the top line, that
2:46
supposedly pure number, requires a heavy dose
2:50
of human judgment. Wait, really? Even just the
2:52
sales number? Yeah, absolutely. Consider, like,
2:56
a software company that sells you a three -year
2:58
subscription to their cloud service. You pay
3:01
for all three years upfront on day one with your
3:04
credit card. Okay, so they have my money today.
3:06
Right, the cash is sitting in the company's bank
3:08
account right now. But under standard accounting
3:11
rules, they cannot record all that cash as revenue
3:13
today. Because they haven't actually delivered
3:16
the three years of work yet. Exactly. They owe
3:18
you a service. The cash in their bank account
3:20
isn't completely theirs, free and clear, until
3:23
they actually provide the cloud hosting for year
3:25
one, year two, and year three. Ah, so they have
3:28
to spread that revenue out over the 36 months.
3:31
as the service is actually delivered to you.
3:34
Yeah. The revenue on the income statement only
3:36
trickles in as it is officially earned. So deciding
3:39
exactly when a service is delivered, especially
3:41
with complex, multi -stage corporate contracts,
3:45
is actually a massive judgment call on timing.
3:48
Wow. OK. So we establish our revenue, but a business
3:52
doesn't get to keep all of that. We have to subtract
3:55
the direct costs of making whatever it is they
3:57
just sold. Right, which gives us the cost of
4:00
goods sold, often referred to as COG -ES. Yeah,
4:03
COG -ES. And subtracting COG -ES from revenue
4:07
leaves us with gross profit. So, to use a very
4:10
grounded analogy here, if you were running a
4:13
lemonade stand, your cost of goods sold is the
4:16
lemons, the sugar, and the paper cups. Just the
4:19
physical component. Right. It is specifically
4:22
the direct materials and the direct labor used
4:25
to build the product. Yeah. It is not, you know,
4:27
the $50 permit you had to buy from the city to
4:30
set up the stand on the sidewalk. Exactly. Cost
4:32
of Goods Sold only cares about what went directly
4:34
into the physical product handed to the customer.
4:38
If I'm looking at two different tech companies
4:40
or even two different lemonade stands, seeing
4:42
that they both report the exact same gross profit
4:45
in raw dollars, say $1 million, that doesn't
4:48
actually tell me if their core businesses are
4:50
equally strong, does it? Not at all. Yeah. Because,
4:52
I mean, $1 million in profit for a company that
4:55
sold $10 million worth of lemonade is vastly
4:58
different from a company that made $1 million
5:00
in profit selling just $2 million worth of lemonade.
5:03
Yeah, looking at the raw dollars is never enough.
5:05
You have to convert that into gross margin. Which
5:07
is a percentage, right? Right. It's the profit
5:10
expressed as a percentage of revenue. And honestly,
5:13
this metric is arguably one of the most informative
5:16
numbers on the entire statement. Why is that?
5:18
Because it is a direct reflection of a company's
5:21
pricing power. OK. And pricing power simply means
5:23
how much a company can mark up their product
5:26
before the customer finally just walks away.
5:28
Exactly. Take a luxury technology brand compared
5:31
to just a generic electronics manufacturer. If
5:34
a company boasts a gross margin of 60%, they
5:38
are charging vastly more for their product than
5:40
it costs to physically manufacture it. Right.
5:43
The customer is willingly paying a massive premium.
5:46
Yeah. And that tells you the company possesses
5:48
something incredibly special, like a strong brand
5:51
identity, or an essential patent, or a captive
5:55
network of users who just refuse to leave. But
5:58
if a competitor has a gross margin of, like,
6:00
5 %? Then they are competing purely on price.
6:02
They have no real leverage over their customer,
6:05
which is a really brutal, exhausting place to
6:08
operate a business. Yeah, I can imagine. And
6:11
as an investor, tracking that percentage over
6:14
time really tells a story. If I see a gross margin
6:16
falling over a three -year period, say drifts
6:20
from 38 % down to 35 and then down to 32, that
6:24
feels like a massive red flag. Oh, absolutely.
6:26
It's a huge warning sign. Because the business
6:29
is likely buying its revenue by quietly slashing
6:31
prices, right, just to keep its customers from
6:34
fleeing to competitors. Yeah. A shrinking gross
6:37
margin is kind of like the earliest tremor before
6:40
an earthquake. It signals that the core product
6:42
is losing its magic in the marketplace. OK, so
6:45
we've bought the lemons, we've made the lemonade,
6:48
and we have established our gross profit. Now
6:51
we have to fund the actual corporate machine
6:53
that surrounds the product. Right, the overhead.
6:55
Yeah. So to map this out, let's bring in the
6:58
running example from our sources. It's this fictional
7:00
manufacturer called Meridian Tool Works. OK,
7:02
I like Meridian. Meridian generated $200 million
7:05
in revenue this year. Their cost of goods sold
7:08
was $130 million. That leaves them with a gross
7:12
profit of $70 million. Which translates to a
7:15
gross margin of 35%. And for a heavy manufacturer
7:19
building physical tools and equipment, that is
7:21
actually a highly respectable number. Yeah, it's
7:24
pretty good. But we still have to pay for the
7:26
corporate machine, though. Right. The permit
7:28
for the lemonade stand, the marketing budget,
7:30
all the executives at the head office. Exactly.
7:33
On the income statement, these are categorized
7:35
as operating expenses, or OPEX. This umbrella
7:40
includes selling, general, and administrative
7:42
costs, usually abbreviated as SG &A. And it also
7:46
includes research and development. Right. And
7:49
crucially, it includes depreciation and amortization.
7:52
For Meridian Tool Works, all of those operating
7:55
expenses add up to $40 million. Okay, so we subtract
7:58
that $40 million from our $70 million gross profit.
8:01
Yep, which leaves $30 million. This line is operating
8:04
income, frequently called EBIT earnings before
8:07
interest and taxes. Before we move past operating
8:09
income, we really need to pause on depreciation
8:12
and amortization. Oh, because that ties back
8:14
to the intro. Yeah. These two concepts perfectly
8:17
resolve the two company paradox we started with
8:20
today. Ah, okay. Let's break down the mechanics
8:22
of that. If Meridian Tool Works buys a $10 million
8:25
factory to build their tools, they don't expense
8:28
that entire $10 million on the income statement
8:31
in year one, right? Right. If they did, it would
8:33
look like they took a massive loss for the year,
8:35
even though they now own this highly valuable
8:37
factory. Right. They traded cash for an asset.
8:40
So what do they do instead? Well, accounting
8:42
rules require them to depreciate the asset. They
8:46
basically spread the cost of that factory out
8:48
over its useful life. OK. And amortization is
8:51
the exact same concept, right? Just apply to
8:53
intangible assets. Exactly. Like a patent that's
8:56
slowly ticking down toward its expiration date.
8:59
Here's where it gets really interesting. Management
9:01
actually gets to estimate what that useful life
9:04
is. Yes, they do. So, company A might decide
9:08
their new factory will last for 10 years, meaning
9:10
they record a $1 million depreciation expense
9:13
every single year. Right. But company B, identical
9:16
in every way, might decide their factory will
9:19
last for 20 years. So they only record a $500
9:22
,000 expense every year. Wow. So, Company B reports
9:26
a higher profit simply because they stretch their
9:29
depreciation timeline. Exactly. No fraud, just
9:32
a different estimate. It highlights why depreciation
9:35
and amortization are called non -cash expenses.
9:39
Because Meridian isn't actually... writing a
9:42
check for depreciation this year. Right. The
9:44
cash left the building years ago when they actually
9:47
bought the factory. The income statement is just
9:49
allocating a portion of that historical cost
9:52
to the current year to sort of match the wear
9:54
and tear on the equipment. Which perfectly illustrates
9:56
why profit is an opinion. It's so subjective.
9:59
It really is. But despite those estimates, drawing
10:02
a heavy line under operating income our EBIT
10:05
of $30 million serves a very specific analytical
10:09
purpose. It does, yeah. Because it allows me
10:11
to compare Meridian's core tool -making engine
10:13
against a competitor's engine before the waters
10:16
get muddy by how those two companies happen to
10:18
be financed. Right. It answers the fundamental
10:20
question of viability. I mean, if Meridian generates
10:23
$30 million in operating income, the underlying
10:26
business of manufacturing and selling tools works.
10:29
Yeah, the core operation is solid. Exactly. We
10:32
haven't looked at their bank loans yet. We haven't
10:35
considered the tax rates of the countries they
10:37
operate in. We are solely evaluating the isolated
10:40
performance of the operational engine. OK, so
10:42
everything below this line is simply list of
10:46
who was standing in line to take a cut of that
10:48
$30 million before the actual owners of the business
10:52
get to see a single dime. Yeah, that's a great
10:54
way to put it. And the first entities standing
10:56
in that line are always the lenders. The banks
10:59
and the bondholders. Right. Meridian borrowed
11:02
money in the past to expand its operations, and
11:05
they have to pay interest on that debt. According
11:07
to their statement, they owe $6 million in interest
11:10
this year. OK, so let's look at the mechanics
11:12
of financial leverage here. Meridian's operating
11:15
engine generated $30 million. Interest immediately
11:19
siphons off $6 million of that. So a full 20
11:23
% of the operating profit goes straight to the
11:25
lenders before the shareholders, the actual owners
11:28
taking all the risk, are even acknowledged. If
11:31
we connect this to the bigger picture, we can
11:33
really see the brutal, amplifying nature of leverage.
11:36
That interest bill is a fixed contractual obligation.
11:40
It doesn't change if things go bad. Right. It
11:42
does not care about the health of the broader
11:44
economy. OK, let me actually game this out. Suppose
11:47
a severe recession hits, construction slows down,
11:51
people stop buying tools, and Meridian's operating
11:54
income falls by a 33 % drop. OK. So instead of
11:59
$30 million, they only generate $20 million in
12:01
operating profit. But the lenders still demand
12:04
their $6 million. Right. So pre -tax income falls
12:07
from $24 million all the way down to $14 million.
12:11
A 33 % operational decline triggers a massive
12:14
42 % drop in pre -tax income. Wow. So financial
12:18
leverage just amplifies the downside. Absolutely.
12:21
It forces the equity holders, the shareholders
12:23
to absorb all of the shock of a bad year. That
12:26
is such a brilliant way to visualize risk. Debt
12:29
acts as a pure amplifier on the income statement.
12:31
It really does. But returning to our baseline
12:34
scenario, Meridian successfully made their $30
12:37
million, paid their $6 million interest, leaving
12:39
$24 million. Then the government takes its cut.
12:43
Right. Taxes. Yeah. Assuming taxes are another
12:46
$6 million, we subtract that and arrive at the
12:49
absolute bottom of the statement, the bottom
12:51
line, net income. Meridian is left with $18 million,
12:57
translating to a net margin of 9%. Arriving at
13:00
net income feels like the finish line, doesn't
13:02
it? It really does. But for you, the listener
13:04
who's evaluating this company, the journey actually
13:06
requires one more step. Because you do not own
13:09
the entire Meridian Corporation, you just own
13:12
a few shares. Right, so you need to know what
13:14
your specific tiny slice of that $18 million
13:17
pie is actually worth. Which requires looking
13:19
at earnings per share or EPS. Right, EPS. So
13:23
Meridian has $18 million in net income. If they
13:26
have exactly 10 million shares floating around
13:28
out there in the public market, the basic EPS
13:31
is $1 .80. Just simple division. Yeah. But scanning
13:34
the income statement, there was always a second
13:37
number printed directly beneath it. Deluded EPS.
13:40
And for Meridian, that number sits at $1 .57.
13:44
Yeah, and that distinction is huge because basic
13:48
EPS just takes the profit and divides it by the
13:51
shares that actually exist today. Right. But
13:53
Deluded EPS asks a much darker question, which
13:56
is, what if everything that could potentially
14:00
become a share actually did? Oh, you mean like
14:03
things that could become a share, like employee
14:05
stock options or convertible bonds? Exactly.
14:09
Tech companies, for example, they issue stock
14:11
options to retain talent all the time. Right.
14:14
But those aren't actual shares yet. No. But the
14:16
employees hold a contractual right to convert
14:18
them into shares at a later date. So Deluded
14:20
EPS assumes that every single employee and bondholder
14:24
pulled the trigger and converted their options.
14:26
Wow. Yeah. It models the absolute worst case
14:29
scenario for your specific slice of the pie.
14:31
In Meridian's case, if everyone exercised their
14:34
options, the share count swells from 10 million
14:36
to 11 .5 million. And here's where it gets really
14:39
interesting. $1 .80 versus $1 .57 is a 13 % gap.
14:46
Yeah, it's significant. That wide of a gap serves
14:49
as a massive warning sign for an investor. It
14:52
signals pending dilution hanging right over your
14:55
head. Yep. And when financial media writes a
14:58
headline about a company's quarterly earnings,
15:00
they almost universally quote, the basic EPS.
15:04
Because it's a higher, more flattering number.
15:06
Exactly. But the diluted EPS is the honest version
15:09
of what you actually own. It reveals a common
15:12
corporate illusion, which leads directly into
15:15
an even more pervasive trick you really need
15:17
to be fiercely protective against. The buyback
15:20
illusion. Yes. A vital diagnostic test you can
15:23
run on any company is to compare the multi -year
15:25
growth of their diluted EPS against the growth
15:28
of their overall net income. OK. Let's follow
15:31
the math on that. If I'm analyzing a company
15:33
and I see their total net income only grew by
15:36
a sluggish 2 % or 3 % over the year, but their
15:39
earnings per share miraculously shot up by 15%.
15:42
Something artificial is happening in the background.
15:45
The management team used the company's excess
15:47
cash to buy back their own stock on the open
15:49
market and retire it. They intentionally shrink
15:53
the total number of shares in existence. So the
15:56
actual pie, the underlying business barely grew
15:58
at all. Right. But because they removed a significant
16:02
number of slices, each remaining slice looks
16:05
mathematically richer. Exactly. And executive
16:08
compensation packages and yearly bonuses are
16:10
very frequently tied directly to hitting specific
16:13
EPS targets. Oh, wow. So if the core business
16:16
is stalling and they can't grow net income organically,
16:20
management has a massive personal incentive to
16:22
authorize a stock buyback. You got it. It artificially
16:25
pumps up the EPS, securing their bonuses, while
16:28
potentially starving the company of the cash
16:30
actually needed for crucial research and development.
16:32
So the EPS looks fantastic on a press release,
16:35
but the core engine of the business is silently
16:37
decaying. Right. This just proves that reading
16:40
the headline is never enough. You really must
16:42
understand the underlying mechanics manipulating
16:44
the denominator. Absolutely. And even after navigating
16:48
the pitfalls of basic versus diluted shares,
16:51
management still retains one final method to
16:54
shape the narrative you hear. Oh, yes. We have
16:56
to talk about non -GAAP measures. Oh, yes. The
17:00
infamous adjusted earnings. Yeah. Companies frequently
17:03
issue press releases championing their adjusted
17:05
earnings, or their EBITDA. EBITDA. Yeah. Which
17:08
stands for earnings before interest, tax, depreciation,
17:11
and amortization. They basically take the audited
17:14
net income we just calculated and start adding
17:17
back all the expenses they wish didn't count
17:20
against them. Which, to be fair, creating an
17:22
adjusted earnings number is not inherently malicious.
17:25
No. No, because the standard accounting rules
17:28
gap are pretty rigid and sometimes they obscure
17:30
the daily reality of a business. Okay, give me
17:32
an example. Well, stripping out a massive one
17:35
-time legal settlement actually helps an investor
17:38
compare the normal day -to -day operations of
17:41
the business year over year. Oh, I see. Yeah.
17:43
And EBITDA is genuinely useful for private equity
17:46
firms trying to compare the pure cash generating
17:49
ability of companies operating under completely
17:51
different capital structures and tax environments.
17:55
OK. But the danger lies in the fact that management
17:58
gets to arbitrarily choose what they consider
18:01
an adjustment. Right. It's exactly like looking
18:03
at your own personal monthly budget and telling
18:06
yourself, well, if I adjust out the time I had
18:08
to fix the transmission on my car and I adjust
18:11
out the emergency vet bill for the dog, I'm actually
18:14
saving a ton of money this year. Exactly. And
18:16
that logic holds up if the transmission breaks
18:18
once a decade. Right. Because it's a true one
18:21
time anomaly. But the illusion shatters when
18:23
you are adjusting out a quote unquote non -recurring
18:27
transmission repair every single year. Yeah.
18:29
At that point, it is recurring. Exactly. It is
18:32
a very real cost of your lifestyle. When companies
18:35
consistently adjust out stock -based compensation
18:37
or write -offs for failed product launches quarter
18:40
after quarter, they are asking you to evaluate
18:42
a fantasy version of their business. Wow. Your
18:45
adjusted budget is describing a reality that
18:47
simply does not exist. The real story is always
18:50
found buried in the fine print. The exact itemized
18:53
list of what management decided to adjust out.
18:55
So, um... What does this all mean for you? You
18:59
basically now have a complete map to navigate
19:02
the income statement. You really do. You start
19:04
at the very top, analyzing the purity and timing
19:07
of the revenue line. You subtract the direct
19:09
costs to find the gross margin, which secures
19:12
your ultimate reality check on a company's pricing
19:15
power and brand strength. Right. Then you deduct
19:17
operating expenses, keeping a really close eye
19:20
on non -cash estimates like depreciation to reveal
19:23
the pure business engine. operating income. Yeah.
19:26
You survive the leverage amplifier, observing
19:29
how fixed interest payments multiply downside
19:32
risk. And finally, you reach the bottom line,
19:35
bypassing the flattering headlines to uncover
19:37
the honest truth by looking exclusively at the
19:39
looted EPS and watching out for the buyback illusion.
19:43
This raises an important question, though, and
19:44
it actually brings us right back to the very
19:46
first concept we discussed today. We established
19:49
today that profit is an opinion. It is an estimate
19:51
full of management choices and non -cash accounting
19:55
expenses. So, here's a final puzzle for you to
19:58
mull over. Let's hear it. What happens when a
20:00
company like our fictional Meridian Tool Works
20:02
reports a perfectly legitimate, fully -audited,
20:06
rule -abiding profit of $18 million on this income
20:10
statement, but simultaneously runs completely
20:14
out of cash and goes bankrupt? Wait. A company
20:16
being highly profitable on paper, but completely
20:20
broke in reality at the exact same time. Exactly.
20:23
The income statement is only a film of the estimated
20:25
profits. It completely ignores the actual hard
20:29
cash flowing in and out of the corporate bank
20:31
account. Oh, wow. Yeah. So to solve the mystery
20:34
of how a profitable company dies of starvation,
20:37
you have to look at an entirely different document.
20:39
Wow. The film might show a triumphant ending
20:41
on screen, but if the studio ran out of actual
20:44
cash to pay the crew, the reality is a lot darker.
20:47
Keep an eye out for those corporate illusions,
20:49
my friend, and always check the director's cut.