What’s it: An income statement tells you the company’s financial performance during a specific period, quarterly or annually. It shows you three basic elements, namely, revenue, expenses, and profit. Other names for the income statement are profit and loss statements and statements of operations.
Income statement formula
Simply stated, the income statement shows you whether the company made a profit or not. The difference between total revenue and total expenses equals net income (or net profit_.
Net profit = Total revenue – Total expenses
You need to remember that in accrual accounting, profit is not equal to the cash that the company posted. Some components of this report contain non-cash items such as depreciation and amortization expenses. To see how much the company is making money, you need to examine another part of the financial statements, the cash flow statement.
Companies must be able to generate more revenue than is spent. Companies need to pay off debt, pay dividends, and have the capital to grow. For this reason, high profits relative to income are more desirable.
Three basic elements of an income statement
When examining the income statement, you will know how much profit the company makes.
The three main elements of making an income statement are:
What is revenue
Revenue is the most straightforward part of the income statement. Often, one number represents a large portion of the money brought by the company during the reporting period, i.e., revenue from product sales or service provision. You can see it in the first line of the income statement – because of that, it’s also called “top line.”
You will also find other revenues, apart from the core business. But, they are usually small or discontinued. Examples are interest income, income from the sale of fixed assets, and currency translation gains.
What is expense
Although there are various types of expenses, the two biggest are the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A expenses).
COGS is costs directly related to the production of goods or the provision of services. It will vary depending on the level of output. It goes up when production goes up and goes down when production goes down. Examples are raw material costs, direct labor costs, and direct overhead costs.
SG&A expenses, or operating expenses, consist of various costs that are not related to production – and are therefore referred to as indirect costs. They are usually fixed costs, although some of them are semi-variable such as selling expenses. Examples of SG&A expenses are marketing expenses, utilities, and management salaries.
In addition to the two types of expense, you might find other expenses in this section, such as:
Depreciation and amortization expenses – represent impairment of fixed assets (depreciation) and intangible assets (amortization). Usually, these expenses are included in the two expenses above, so you might not see them listed separately in the income statement.
Other operating expenses – covers all other expenses related to the company’s primary operations but does not fall into the two categories above. These expenses are generally unrecurring, and therefore, sometimes the company presents them and sometimes not.
Interest expense – represents the money the company pays the lender. As long as it still has interest-bearing debt, the company will report this expense regularly in the income statement. You can check the details of the debt, interest expense, and interest income on notes to financial statements.
Tax expense – is the tax burden on profits by companies to the government.
What is profit
Profit is revenue left after deducting expenses. Some sub-categories of profit are gross profit, operating profit, and net profit.
Gross profit equals income minus COGS. This metric shows the amount of money left after the company covered production costs. Ideally, the company has a gross profit large enough to cover other operating expenses.
Operating profit equals revenue minus SG&A expenses. This number tells you how much profit the company is making from the core business.
Finally, net income, i.e., profit remaining after adding non-operating income (expense) and tax expense. Examples of non-operating income (expense) are income from the sale of fixed assets, exchange rate profit (loss), and interest income (expense). Net profit is often called the ” bottom line ” because it is at the end of the income statement.
If it owns most of the shares of a subsidiary, it must present a consolidated financial statement. Consolidation requires the parent company to incorporate all revenue and expenses of the subsidiary with its own. The company then presents the combined results on the income statement. If the subsidiary is not wholly-owned, it deducts net income to minority interests (or non-controlling interest).
Why the income statements matters
An income statement gives you insight into a company’s performance and profitability. It is, therefore, an essential source of information for financial statement analysis. This report tells you:
- How much money the company earns (revenue)
- How much is spent (expense)
- What is the rest (profit)
Two approaches to analyzing the income statement:
- First, you compare the critical accounts from time to time.
- Second, you can use several financial ratios.
You might also need to compare the two with the peer companies or industry average to get deep insights.
Only by using an income statement, you can calculate profitability ratios such as gross profit margins, operating profit margins, and net profit margins. Such metrics help you assess a company’s ability to turn revenue into profit. For other financial ratios, you need to read other parts of the financial statements, namely balance sheets and cash flow statements. Examples are the return on assets (ROA), return on equity (ROE), accounts receivable turnover, current ratios, quick ratios, and interest coverage ratio.