Financial Statement Analysis: Income Statement 2

Understanding the Difference Between Net Income and Income Before Tax

Net income and income before tax are terms that often appear when reading financial statements, and while they may seem similar, they actually represent different concepts. Both are indicators of a company's profitability, but they differ in their calculation methods and meanings.

• Income Before Taxis calculated by subtracting the cost of goods sold, selling and administrative expenses, and other operating income from revenue, and then adding other operating expenses and income tax expense. In other words, it represents the profit before taxes are paid.
• Net Incomeis the value obtained by subtracting income tax expense from income before tax, representing the final profit a company earns after paying all expenses.

Therefore, by comparing these two indicators, you can understand the level of a company's tax burden and the size of its actual profits. If income before tax is high but net income is low, it indicates a heavy tax burden. Conversely, if net income is high but income before tax is low, it can be interpreted as a large amount of other operating expenses or tax benefits received.

Assessing Financial Health through Key Financial Ratio Analysis

When analyzing an income statement, using key financial ratios can help you objectively assess a company's financial condition. Some representative financial ratios include the following.

• Profitability Ratios:These indicators reflect how efficiently a company generates profits. Representative profitability ratios include return on assets (ROA), return on equity (ROE), and operating profit margin. These metrics can be used to evaluate a company's profitability and compare it to its competitors.
• Solvency Ratios:These indicators reflect a company's financial stability. Representative solvency ratios include the debt-to-equity ratio, current ratio, and quick ratio. These metrics can be used to assess a company's ability to repay its debts and its risk of short-term default.
• Activity Ratios:These indicators reflect how efficiently a company utilizes its assets. Representative activity ratios include inventory turnover ratio and accounts receivable turnover ratio. These metrics can be used to evaluate a company's asset utilization and identify areas for improvement.
• Growth Ratios:These indicators reflect a company's growth trend. Representative growth ratios include revenue growth rate, operating income growth rate, and net income growth rate. These metrics can be used to evaluate a company's growth potential and predict its future outlook.

By comprehensively analyzing these financial ratios, you can gain a more accurate assessment of a company's financial condition and business performance. This information can then be used to develop corporate strategies and make investment decisions.

Methods for Analyzing Changes in the Income Statement

When analyzing an income statement, understanding changes is crucial. This allows for a more accurate understanding of a company's business performance and financial condition.

Here are the methods for analyzing changes:

• Analysis of Revenue Changes:This is one of the most important items. An increase in revenue signifies improved company profitability and enhanced growth potential. Conversely, a decrease in revenue can lead to a decline in profitability and potential crises. Seasonal factors, economic fluctuations, and the emergence of competitors should be considered.
• Analysis of Expense Changes:Along with revenue, this is a crucial element that directly impacts a company's profitability. Analyze fluctuations in labor costs, material costs, advertising costs, etc., and explore their root causes. This helps identify ways to reduce expenses and improve profitability.
• Analysis of Changes in Non-Operating Income and Expenses:Analyze changes in interest income, interest expense, dividend income, etc. This helps evaluate a company's financial stability and aids in developing capital procurement plans.
• Analysis of Changes in Corporate Income Tax Expense:Corporate income tax expense is a critical factor in determining a company's ultimate profitability, so it should be thoroughly examined. It can be affected by tax audits and changes in tax laws.
• Analysis of Changes in Net Income:Finally, analyzing fluctuations in net income is also important, and it requires a holistic review of the above elements. This allows for the assessment of a company's business performance and prediction of its future outlook.

Practical Income Statement Reading Practice and Summary through Case Study

Now, let's practice reading an actual income statement. Below is the income statement for a hypothetical company, Company A, for 2021.

Account Item

Amount

Revenue 100,000,000 KRW

Cost of Goods Sold 60,000,000 KRW

Gross Profit 40,000,000 KRW

Selling and Administrative Expenses 20,000,000 KRW

Operating Income 20,000,000 KRW

Other Operating Income 5,000,000 KRW

Other Operating Expenses 3,000,000 KRW

Income Before Tax 22,000,000 KRW

Income Tax Expense 4,400,000 KRW

Net Income 17,600,000 KRW

The above income statement can be summarized as follows:

-Revenue in 2021 was 100 million KRW, and the cost of goods sold was 60 million KRW.
-Gross profit was 40 million KRW (Revenue - Cost of Goods Sold).
-Selling and administrative expenses were 20 million KRW.
-Operating income was 20 million KRW (Gross Profit - Selling and Administrative Expenses).
-Other operating income was 5 million KRW, and other operating expenses were 3 million KRW.
-Income before tax was 22 million KRW (Operating Income + Other Operating Income - Other Operating Expenses).
-Income tax expense was 4.4 million KRW, and net income was 17.6 million KRW (Income Before Tax - Income Tax Expense).

Conclusion

Today, we've learned how to check a company's profitability using the income statement. The income statement is arguably the most important of the financial statements, so it's essential to remember this information and use it effectively.