Before reading further, I will explain what you will get from this article. What is an income statement and why it is important to read it is the first point. Next, you will read about how companies report revenues and expenses under accrual accounting. I’ll also detail the income statement items plus some formulas for profit. If you only read the income statement, what insights would you get and how to analyze it.
What is an income statement?
Income statement is a section of the financial statements containing information about the company’s revenue, expenses, and profits. It reports the company’s performance during the accounting period, which can be quarterly or annually. Also called a statement of operations, profit and loss statement, or statement of earnings.
When you check it, you will find accounts like revenue; cost of goods sold; selling, general and administrative expenses; interest expense; tax expense; and net income.
The general equations in this report are:
Profit = Revenue – Expense
In the end, you’ll find net income, which represents the profit remaining after all revenues minus all expenses. But, it is not the same as the amount of money earned by the company under accrual accounting because it contains non-cash items such as depreciation, amortization, and impairment charges.
Guide to Understanding and Analyzing Financial Statements
Income statement vs. comprehensive income statement
The comprehensive income statement combines the income statement and other comprehensive income.
- Other comprehensive income reports the results of transactions or events unrelated to investments from or distributions to owners but affects equity.
- Examples are unrealized gains and losses on available-for-sale investments and those arising from currency translation. It is presented as accumulated other comprehensive income in shareholders’ equity.
Why do you need to read the income statement?
The income statement is the most critical part of the financial statements besides the balance sheet and cash flow statement. The balance sheet tells what the company owns (assets) and who has the right to claim (liabilities and shareholder equity). On the cash flow statement, you see how much money is coming in and going out of the company. Meanwhile, the income statement presents revenue, expenses, and the difference between the two, profit.
The income statement shows you the company’s financial performance during the reporting period. If you examine and analyze it, you can determine whether the company is making a profit. How much does the company make from selling a product or offering a service? How much must the company pay to generate the revenue?
External users regularly review the income statement to understand how well the company is performing. The numbers in it, especially the profits, are the ones to look at. In general, profit indicates the company’s ability to generate money, although the concepts of profit and cash are slightly different under accrual accounting.
- Stock investors like profits because it affects the dividends they receive. In addition, they use it to compare whether a company’s current stock price is too expensive, cheap, or fair relative to their ability to generate profits.
- Creditors compare the company’s profit-generating ability with their current debt. If profits are high, they are confident the company can meet its current obligations.
- The government likes it when companies make a profit. First, it is subject to corporate tax. Second, if many companies post profits, it indicates the economy is prospering. They are likely to expand, creating more jobs and income for households.
- Competitors like it when the company makes less profit than it does. It may indicate the company is failing to generate revenue or is less efficient at managing costs.
Furthermore, employees or management are also happy if the company makes a profit. Their bonuses are often tied to the company’s profits. If the profit is higher, they get more bonuses.
How does the company report its revenue?
Revenue recognition is an accounting principle for determining when a company should report revenue. Under accrual accounting, revenue recognition is independent of cash receipts. Accordingly, the company recognizes revenue when it is incurred, not when cash is received.
It contrasts with cash accounting. The company recognizes revenue only when it receives cash payments.
Because revenue recognition is independent of cash payments, accrual accounting results in two related accounts in the financial statements:
- Unearned revenue. Also known as deferred revenue.
- Unbilled revenue. Also known as accrued revenue.
In the first case, the company receives payment for future delivery of goods or provision of services. As a result, cash in assets increased, and at the same time, the company did not report it as revenue but instead reported it as unearned revenue in liabilities.
- When the company has delivered the goods or services, it reports revenue and reduces the unearned revenue account to the same amount.
In other cases, the company has delivered goods or provided services but has not yet received payment. We call it accrued revenue. Companies report revenues on the income statement and record accounts receivable in assets.
- When a cash payment has been received, the company records it in the cash and cash equivalent account. At the same time, the company deducts the same amount from accounts receivable.
Specific cases for revenue recognition
Revenue recognition sometimes involves more complex calculations or, at the very least, requires estimation, not just calculating the amount billed to the customer.
Long term contract
A long-term contract is a contract that is effective for several accounting periods (more than one year). Construction contracts are an example. So how do companies recognize revenues and expenses for each accounting period? Do they have to wait for the contract to be completed and the building to be handed over to the customer?
- If the contract outcome can be measured reliably, the company uses the percentage-of-completion method.
- However, the company uses the completed contract method under U.S. GAAP if it cannot be measured reliably. Under IFRS, companies recognize revenue for the costs incurred during the accounting period; no profit is recognized until the contract is completed.
The percentage-of-completion method recognizes revenue by allocating profit in proportion to the amount completed each accounting period over the contract’s life. First, the company estimates what percentage of contracts are completed for each reporting period. Then, it reports revenues, expenses, and profits to the income statement proportionally according to those percentages.
The completed-contract method recognizes revenue in the income statement only when the contract is completed. Before completion, there was no recognition of revenues and expenses. The company accumulates bills and expenses to the construction-in-progress account in assets instead of recognizing them as an expense.
Installment sales
Customers sometimes do not pay in full for the goods purchased. They pay in installments. They make a certain set of payments for some time to come.
- For example, you buy an item for $100. Instead of having to pay all at once, the seller may let you pay $10 every month for the next ten months.
So how do companies recognize such revenue?
- Under the installment method, companies recognize profits in the income statement when cash is collected. To calculate the share of profit recognized in each period, the company calculates it based on the percentage of cash received from the total sales price. This method is used when the collectibility of revenues cannot be reasonably estimated.
- Under the cost recovery method, the company doesn’t recognize any profit related to the sales transaction until the customer’s cost element has been paid in cash. In other words, the company recognizes profit after the total cash receipts exceed the total costs. This method is used when the collectibility of revenues is highly uncertain.
How does the company report its expenses?
The matching principle states that a company recognizes expenses in the same accounting period as the related revenue. Thus, when the company posted revenue, costs incurred to generate such revenue should be recognized in the income statement at the same time.
But, sometimes, some expenses cannot be directly related to revenue generation like general administrative expenses. Thus, companies cannot directly adjust them to the time the revenue is earned. In accounting, we call them period costs, which are expensed in the period in which they are incurred.
Furthermore, under cash accounting, companies recognize expenses when they have paid cash. In other words, when a company reports an expense, that’s when the cash comes out.
But, under accrual accounting, companies recognize revenue when it is incurred, regardless of when it is paid for. That brings up two other accounts in the financial statements, which are important for you to check.
- The company has paid for goods and services to be provided in the future. Companies report it as a prepaid expense in assets – as an asset because it generates future economic inflows. And at the same time, the company recognizes a decrease in cash and cash equivalents at the same amount. When it has received the goods, the company recognizes it as an expense and, at the same time, reduces the prepaid expense at the same nominal.
- The company has received the product or service but paid for it later. The company recognizes expenses in the income statement and, at the same time, records an accrued expense in liabilities. After being paid, the company deducts the accrued expense and cash and cash equivalents at the same amount.
What are the income statement accounts?
Revenue
Revenue refers to the inflow of economic resources to the company during a certain period. For example, it may be cash inflows from the sale of goods and services. Alternatively, it can also come from an increase in other assets.
Revenue tells you how much money the company makes. However, it is not always the same as cash received under accrual accounting, as I explained earlier. For example, some companies may record revenue, but customers pay for it at a later date. So, on the income statement, the company reports it as revenue, and since it has not yet received the payment, it reports the same amount to accounts receivable.
The company must collect receivables from customers. Some may be successful, and others may not. Then, the company estimates how much it is uncollectible and reports bad debts as an expense on the income statement.
Furthermore, in a more general definition, revenue comprises sales, gains, and investment income. But, in a more specific definition, it usually refers to sales, which a company earns from selling goods.
- Sales – a synonym for revenue. It is used to refer to the proceeds from selling a tangible product (goods). Meanwhile, revenue also includes the sale of services, not just goods.
- Gains – profits realized not from core activities. An example is a gain from foreign currency translation by a manufacturing company.
- Investment income – money earned from investments such as dividends, interest, and capital gains.
In some reports, you may also find companies reporting revenue as net revenue or gross revenue.
- Gross revenue – the total value of product sales, as reflected in the amount stated on the invoice sent to the customer. It has not been subtracted by the deductible components.
- Net revenue – the net value of the sale of goods and services of the company. It equals gross revenue minus deductible components such as allowances, discounts, and returns.
Net revenue = Gross revenue – Deductible items (allowances, discounts, and returns)
Expense
Expenses represent outflows of economic resources, use of assets, or incurrence of liabilities for revenue-generating operations. Accordingly, it decreases equity during the reporting period (other than a decrease due to distributions to owners such as dividends).
Cost of goods sold (COGS) – the cost of generating revenue. COGS represents all direct costs associated with the manufacture and warehouse of company goods. It equals the cost of goods available for sale minus ending inventory. The cost of goods available for sale is equal to beginning inventory plus purchases.
- Cost of revenue – COGS plus costs of service. It represents the total cost involved in making and delivering the product or service to the consumer.
- Some companies may not report COGS but rather the cost of revenue. They might break this figure down into COGS and cost of service. Or, they simply report the cost of revenue and provide the details in the notes to the financial statements.
Selling, general and administrative expenses (SG&A expenses) – expenses related to day-to-day non-production operations such as marketing, sales, and administrative activities. SG&A expenses are sometimes referred to as operating expenses because they represent expenses related to its operations.
- Selling expenses – arising from the company’s efforts to generate sales. It is usually related to distribution, marketing, and sales expenses, such as advertising expenses, sales commissions, salesperson salaries, and media spending.
- General expenses – related to activities to support the administration and non-operating activities. Examples are utilities, rent, computer supplies, and equipment.
- Administrative expenses – related to operations to manage and run the business. Examples are salaries, professional staff, expenses related to general functions such as accounting and information technology.
Depreciation expense – the amount charged to reflect the portion of fixed assets – sometimes presented as property, plant, and equipment or PP&E – consumed during the reporting period. It represents a decrease in the economic benefits of fixed assets during the reporting period. It is accumulated and used to reduce fixed assets, whose net value is presented in non-current assets. It does not generate cash outflow because it is a non-cash item.
- You may find this account on the income statement. But, in some companies, it does not appear, and you have to look for it in the finance notes in the discussion of fixed assets. Companies usually present the details. Alternatively, you can also calculate it by subtracting the current period’s accumulated depreciation balance by the previous period’s accumulated depreciation balance.
Amortization expenses – similar to depreciation expenses. Only, it applies to intangible assets. Like depreciation, it is also a non-cash item. If it is not presented, you can look for it in the notes to the financial statements.
Interest expense – costs for debt held by the company such as bank interest and bond coupons. Companies routinely pay them even when revenue is falling.
- Sometimes, companies combine it with interest income and report it as net interest. In other cases, the two accounts are listed separately.
- Furthermore, in the financial statements, the company may also combine it into finance expense, which not only includes interest expense but also combines it with other items such as rent expense. You should check the notes to the financial statements for details.
Tax expense – the total amount of tax paid by the company to the tax authorities. It equals the amount of income tax owed to the government and any changes in deferred tax assets and liabilities.
Profit
Profit is the remaining revenue after deducting the related expenses. We also call it the term income or earnings. There are various profit measures, including gross profit, operating profit, EBITDA, EBIT, profit before tax, and net income.
- Loss – revenue is less than expenses. In financial statements, the term is more used to refer to a decrease in net income from non-core activities such as an impairment loss on an asset or when selling an asset for less than its carrying amount. Meanwhile, companies use the term “profit” in the income statement even though they report losses – only the numbers presented are minus or in parentheses.
Gross profit – revenue minus cost of goods sold (COGS). Also known as gross margin. It represents the revenue remaining after the company pays the direct costs associated with producing the product.
- Gross profit = Revenue – COGS
Operating profit – gross profit after deducting operating expenses. Operating expenses usually refer to SG&A expenses. It represents the profit from the core business. Also known as operating income.
- Operating profit = Gross profit – SG&A expenses
- Operating profit = Revenue – COGS – SG&A expenses
In theory, operating income considers only recurring expenses such as COGS and SG&A expenses. However, in practice, companies may sometimes include non-recurring costs such as write-offs – as they relate to the core business – in calculating operating profit. Hence, you need to look closely at the income statement to find such cases. You might exclude those items to make a more reasonable comparison with other companies. Or, you might include them in the calculations.
Earnings before interest and tax (EBIT) – a measure of earnings before adjusting for interest and taxes.
- EBIT = Revenue – COGS – SG&A expenses; or
- EBIT = Net profit + Tax + Interest
The first formula is equal to operating profit. Meanwhile, the second is more volatile because it includes non-operational results such as gains (losses) on currency translation, sales of fixed assets, etc.
Earnings before interest, tax, depreciation, and amortization (EBITDA) – EBIT after adjusting for non-cash components such as depreciation and amortization expense. It tells how much money a company makes before paying taxes and interest.
- EBITDA = EBIT + Depreciation and amortization; or
- EBITDA = Revenue – COGS – SG&A Expense + Depreciation and amortization; or
- EBITDA = Net income + Tax + Interest + depreciation and amortization
Net operating profit after tax (NOPAT) – measures the earnings power by excluding tax savings from debt. Many companies benefit from having debt because the interest is tax-deductible. So, this ratio ignores such benefits.
- NOPAT = Operating profit x (1- Tax rate); or
- NOPAT = EBIT x (1 – Tax rate)
Earnings before interest after taxes (EBIAT) – measures how well a company generates profit regardless of how it is financed (debt or equity).
- EBIAT = EBIT x (1- Tax rate) → equal to NOPAT if EBIT = Operating profit
- EBIAT = Net profit + Interest – Tax
Pretax profit – measures how much profit the company made during the reporting period before some were paid to the government as tax. Also called pretax income, pretax earnings, earnings before tax (EBT), and profit before tax.
- Pretax profit = Operating profit + Non-operating gain (loss)
Net profit – measures the company’s profit after paying all its expenses, including taxes and interest, but taking into account non-cash items (such as depreciation and amortization). Hence, it is not equal to the total money the company made during the reporting period. Also known as net income, the bottom line, or net earnings.
- Net profit = Total revenue – Total expense
- Net profit = Pretax profit – Tax expense
Earnings per share
Earnings per share (EPS) measures approximately how much common shareholders earn if the company pays all of its net income as dividends. It is an approximate number, as it does not reflect the amount of money earned. Again, net income is not the same as the money the company makes.
EPS = (Net income – Preferred dividend)/Weighted average number of shares outstanding
Preferred dividends refer to dividends for preferred stockholders. Although they don’t have voting rights, they have the first right to receive dividends before distributing them to common stockholders. It is deducted because it is not included in the expense on the income statement in the calculation of net income.
The weighted average number of shares outstanding is the number of shares outstanding during the year, weighted in proportion to the year in which they were outstanding. It is adjusted for corporate actions such as stock splits and stock dividends, affecting outstanding shares.
Furthermore, if it does not have dilutive securities, the company only reports basic EPS as described above. However, if any, the company reports basic EPS and diluted EPS.
Effects of corporate actions on EPS
Several corporate actions affect the number of shares outstanding:
Share repurchase or stock repurchase. The company is recalling – and therefore reducing – its outstanding common stock, possibly to push up its share price and improve financial ratios.
- Companies usually take this corporate action when the market has discounted its shares too high, and the company has enough cash to buyback. Also known as stock buyback.
Stock splits. The company splits one share into several shares. It increases the number of outstanding shares as it adds new shares. For example, a 3:1 stock split means the existing shareholders are entitled to 2 new shares for each share owned. If the current number of shares outstanding is 1,000 shares, after the stock split, it becomes 3,000 shares. EPS fell as the number of shares outstanding increased. Meanwhile, enterprise value did not change.
Stock dividends. Companies pay dividends by providing additional shares to existing shareholders instead of cash. As a result, the number of outstanding shares increased but did not affect the company’s cash balance.
Diluted EPS
Diluted earnings per share (diluted EPS) is if all the diluted securities were exercised, how much would the common stockholders get. In other words, it is EPS if all dilutive securities are converted into common stock.
Diluted EPS = (Net income – Preferred dividend)/(Weighted average number of shares outstanding + New common shares issued at conversion)
Convertible securities are financial instruments in which the holder has the right to convert them into other securities – in this case, common stock – of the same issuer. Examples are convertible bonds, stock options, convertible preferred stock, and warrants.
- Simple capital structure – if the company does not have convertible securities in its capital composition. Thus, no dilutive effect is on the EPS calculation.
- Complex capital structure – if the company has convertible securities.
Does executing convertible securities lower EPS?
- Dilutive securities – when convertible securities are exercised, the number of common shares outstanding increases, resulting in a lower diluted EPS than the basic EPS.
- Antidilutive securities – if the conversion does not result in a lower diluted EPS than the basic EPS. Hence, they are not taken into account when calculating diluted EPS.
What are non-recurring items?
Non-recurring items occasionally appear in the financial statements. They are not from normal operations but rather from unusual or one-off events. However, their value can be significant. Thus, they have a major impact on profit fluctuations. They occasionally appear in a certain period but then do not appear again in the next period. An example is an income from divesting a subsidiary or selling assets.
And in accounting, they fall into two groups:
- Discontinued operations refer to the part of the business in which the company decides not to continue or sell it to other parties. To improve the comparability of operating income from year to year, companies report it separately from continuing operations in the income statement.
- Extraordinary items are items related to material events and transactions, are outside the ordinary business operations, and are non-recurring.
How to analyze the income statement?
Suppose you only rely on the income statement. In that case, there are two methods you can use to analyze it: vertical analysis and horizontal analysis.
Now, let’s standardize the income statement to be as follows:
Horizontal analysis
Horizontal analysis compares an account with its value in a given year (base year). Long story short, it’s a historical comparison. You review and compare changes in the dollar amounts of each account on the income statement for several reporting periods. Then, for easier interpretation, you can convert it to percent.
First, you select a specific year as the base year. Then, make the number as 100 percent. Say, the year 2018 is selected.
Second, divide the numbers in the same account after the base year by the numbers in the base year, multiply the result by 100%. Say, revenue in 2018 was IDR73,395 billion and 2019 was IDR76,593 billion. So, when converted to a percent, it becomes (76,593/73,395) * 100% = 104%.
Third, do the same calculation for all accounts on the income statement. The results are as follows:
How to read it?
See revenue on the top row. Its percentage in 2020 is 111%, showing its increase compared to the figure in 2018. What is the percentage increase? That equals 11% (111%-100%). Likewise, net profit after MI, in the bottom row, shows a figure of 155%, which means it is an increase of about 55% compared to 2018.
In addition to the above method, you can also calculate the percentage growth for each account every year. It is useful to see an increasing (decreasing) trend over time. Take revenue, for example.
- In 2019: [(76,593 – 73,395)/73,395] * 100% = 4%
- In 2010: [(81,731 – 76,593)/76,593] * 100% = 7%
For 2020, if you add up the percentage growth with 2019, it is equal to 11% or about 111% higher than 2018.
Vertical analysis
Vertical analysis compares the accounts on the income statement as a percentage of total revenue for the same year. That’s useful for answering the question: what line items contribute the most to profits? Which expenses most significantly reduce the company’s revenue?
From the vertical analysis, you will get several profit margin ratios. The ratio you get depends on the standardized report format you use. Let’s say, we take it for 2020. For the above report, we get the following profit margins:
- Gross profit margin = (26,752/81,731) * 100% = 33%
- Operating profit margin = (12,889 /81,731) * 100% = 16% (2018: 12%; 2019: 13%)
- Pre-tax profit margin = (12,426 /81,731) * 100% = 15%
- Net profit (before MI) margin = (8,752 /81,731) * 100% = 11%
Now, take it at random. Pay attention to operating profit margins. You can see, it increased from 13% in 2019 and 16% in 2020. What caused it?.
Selling expenses were unchanged compared to before, reducing about 11% of the company’s revenue. Likewise, general and administrative expenses reduced about 6% of the company’s revenue, unchanged from the previous year. Meanwhile, other operating income contributed a minimum, less than 0.5% (so if rounded up, it is 0%).
The increase in operating profit margin was due to the cost of goods sold (COGS) contributing less than the previous year. If in 2019, it reduced about 70% of the company’s revenue, then in 2020, it only reduced 67%.
Is COGS decreasing?
You can see the numbers are going up. However, the increase (2.0%) was lower than the increase in income (6.7%).
Profit margin
Profit margins are basically the result of vertical analysis, as I described above. It shows what percentage of revenue remains after the company pays related expenses. A higher ratio is more desirable because the company posted a larger profit for each revenue earned.
Calculating profit margins is easy. First, take the profit measures as I discussed earlier, and divide them by revenue.
- Gross profit margin = Gross profit/ Revenue
- Operating profit margin = Operating profit / Revenue
- EBIT margin = EBIT / Revenue
- EBITDA margin = EBITDA / Revenue
- NOPAT margin = NOPAT / Revenue
- EBIAT margin = EBIAT / Revenue
- Pretax profit margin = Pretax profit / Revenue
- Net profit margin = Net profit/ Revenue