You hear a lot about the bottom line, which refers to the net earnings or income after all expenses, taxes, and extraordinary items are factored in. The bottom line is the final net measure of all business activity.
Other important lines in the earnings statement reveal key factors and trends in the business. Youll see these lines or items in various forms on financial statements depending on the statement and sometimes the industry.
There are many ways to measure income. Each reveals an important layer of business performance, both for determining intrinsic value and also for comparing companies. Among them are Gross profit: This is simply the sales less the direct cost of producing the companys product or service. Direct cost includes labor, material, and expenses directly attributable to producing it. Gross profit, often called gross margin, is the purest indicator of business profitability. Value investors closely watch gross margin trends as an indicator of market dominance, price control, and future profitability.Operating profit: Operating profit, often referred to as operating income, is gross profit less period expenses —overhead or marketing costs not directly attributable to product production. Operating profit gives a more complete picture of how the business is performing on a day – today basis. Period expenses typically include selling, general, and administrative expenses, and amortization. Typically excluded are financing costs, such as interest and taxes, as well as items deemed as extraordinary.
Net income: This represents the net result of all revenues, expenses, interest, and taxes.
There are other supplemental earnings measures such as free cash flow, discussed later in this chapter. The following sections explore the key components of an earnings statement.
