A Beginner’s guide to The Income Statement – A simple analogy

I decided to start a beginner guide to the basics of Fundamental Analysis starting with The Income Statement. I want to record my knowledge somewhere and what better way than to blog about it? It is also in fact beneficial to me whenever I pen down my thoughts because I’m sort of materializing whatever that is going through my mind, which in turn challenges my understanding towards the topic. Plus, I get a chance to receive some constructive feedback from my readers. Win-win! 🙂

I refer to a quote from Einstein:

If you can’t explain it simply, you don’t understand it well enough.

Smart fellow

Let’s get down to business (pun intended? :p). I’ll start by using a simple analogy.

You have a very good friend, Christopher. Chris is an ambitious man. He recently became his very own Towkay (boss) by setting up a stall to sell Hainanese Chicken Rice.

Best in SG, JB and some say Batam! 

It has been one year since he started the business and he would like to review how well he has done. Here are some numbers that he collected:

1. He has sold a total of 10,000 plates of chicken rice at $3 each.
2. His net cost for 1 plate of chicken rice is $0.50.
3. He opened his shop in a Kopitiam which charged him $1000 per month for rental. This amounts to $12,000 per year.

This is how the above statements will be translated onto a typical Income Statement:

	Description	The Math	Total
Revenue	Total sales	$3 x 10,000	$  30,000
Gross profit	Revenue – Net cost	$30,000 – ($0.50 x 10,000)	$  25,000
Net income	Revenue – Net cost – Rental	$30,000 – ($0.50 x 10,000) – ($1000 x 12)	$  13,000

He has earned a profit of $13,000 for his first year of operation, which is about 43.4% of his entire revenue! Not too shabby eh?

Upon realization that there is a chance for higher earnings, he has plans to expand this business by renting another chicken rice stall in another Kopitiam. The problem was that he does not have any additional money at the moment.

He decided to pull the trigger and ask for your help. He calls you one day and asked you to invest in his business. He proposed that for a sum of $10,000 that you are willing to put out on the table for him, he will allow you to own 25% of his business and will provide you with an annual return of 10% of whatever that he earns.

“My, my… A new business opportunity!”, you think to yourself. Since he is such a good friend of yours, and you have seen how well his Chicken Rice stall has done in the first year, you decided to put your trust (and money) in him. He is very happy and calls you the pioneer shareholder for the company. ^_^

The second year of operation has just ended and both of you sit down to review the numbers again.

1. Having two stalls, he managed to sell a total of 25,000 plates of chicken rice at $3 each.
2. His net cost for 1 plate of chicken rice is maintained at $0.50 still.
3. Both stalls have the same rental cost at $1000 per month.
4. He hired a new assistant in which he paid $1,200 per month to help him to tend his second stall.

Updating the table…

	Description	The Math	Total
Revenue	Total sales	$3 x 25,000	$   75,000
Gross profit	Revenue – Net cost	$75,000 – ($0.50 x 25,000)	$   62,500
Net income	Revenue – Net cost – Rental – Staff salary	$75,000 – ($0.50 x 25,000) – ($1000 x 2 x 12) – ($1200 x 12)	$   24,100
Shareholder earnings	25% of Net income	25% x $24,100	$  6,025.0
Shareholder Dividend	10% of Net income	10% x $24,100	$  2,410.0

The earnings for the second year has increased from a mere $13,000 to $24,100 due to the increase in sales. However, in comparison to the total revenue, his business’ earnings have decreased to only 32.1%, which is a 10% decrease from the previous year. This can be attributed mainly to the increase in operating costs in rental and staff salary. Also, he cannot pocket the entire $24,100 because he wouldn’t have been able to expand this business without your help.

As a (one and only) shareholder, 25% of the earnings would be attributed to you, which amounts to $6,025. Not too bad for you because that is more than 60% of your initial capital of $10,000. It clearly shows that your $10,000 has made a significant (positive) impact to the health of Chris’ business.

Not forgetting his promise to you, he has rewarded you the return of 10% of whatever he has earned, which is in this case, $2,410. This results in a 24.1% return on your invested capital, which you should know is WAY, WAY, WAY (needed to add a third one for emphasis) higher in comparison to paltry bank interest rates. If his business is able to provide you with the same 24.1% return (or dividend yield as we call it in equity investing) year-on-year, you would have gained back your initial capital slightly more than 4 years!

In reality, as you might be aware, the returns may not be as fascinating as the above analogy (even if you really did have an ambitious friend named Chris). However, the same fundamental concepts apply to the basic understanding of any income statement that you will find in a company’s annual report.

I hope this article was useful to you as it has been for me. If you find any information wrong/amiss, please let me know by leaving a comment/email so that I can improve it.

Click here for A Beginner’s guide to The Balance Sheet – A simple analogy for a continuation to this post!

Thanks for reading!

Miss Niao xoxo