Understanding the income statement
What is the income statement?
The income statement is one of the three financial statements that equity investors rely on. (The others are the balance sheet and the cash flow statement.) Understanding an income statement is essential for investors who want to analyze the profitability and future growth of a business.
Key points to remember:
- The income statement summarizes the income and expenses of a business over a period, quarterly or annually.
- The income statement comes in two forms, in several stages and in a single stage.
- The multi-step income statement includes four measures of profitability: gross, operating, pre-tax and after-tax.
- The income statement measures profitability and not cash flow.
In the context of corporate financial reporting, the income statement summarizes the income (sales) and expenses of a business, quarterly and annually, for the year. The final net figure and other figures in the statement are of major interest to investors and analysts.
An introduction to the income statement
Understanding the income statement
The income statements are accompanied by various nicknames. The most commonly used are “income statement”, “income statement”, “income statement” and “statement of operations”.
Many professionals still use the term P&L, which stands for income statement, but this term is rarely printed these days.
The words “profits”, “earnings” and “income” all mean the same thing and are used interchangeably.
Two basic formats for the income statement are used in financial reporting: multi-step and single-step. These are illustrated below in two examples:
|Multi-step formatting||One-step format|
|Net sales||Net sales|
|Cost of sales||Materials and fabrication|
|Gross revenue*||Marketing and administration|
|Selling, general and administrative expenses (SG&A)||Research and development (R&D) costs|
|Operating result *||Other income and expenses|
|Other income and expenses||Income before taxes|
|Income before taxes *||Taxes|
|Net income (after tax) *||–|
In the multi-step income statement, four measures of profitability (displayed with an asterisk *) are revealed at four critical points in a company’s operations: gross, operating, pre-tax, and after-tax.
In the one-step presentation, gross and operating profit figures are not shown. They can be calculated from the data provided. In this method, sales minus materials and production are equal to gross income. By subtracting the expenses of marketing, administration and research and development (R&D) from the gross income, we obtain the operating result.
Investors should keep in mind that the income statement recognizes income when it is earned, that is, when goods are shipped, services rendered and expenses incurred. With accrual accounting, the flow of accounting events through the income statement does not necessarily coincide with the actual receipt and disbursement of cash. The income statement measures profitability, not cash flow.
Income statements (multi-step format)
- Net sales (sales or revenue): this is the value of a company’s sales of goods and services to its customers. While the bottom line of a business (its net income) gets the most attention from investors, the bottom line is the starting point of the income or income process. In the long run, profit margins on a company’s existing products tend to reach a maximum that is difficult to improve. Thus, businesses generally cannot grow faster than their income.
- Cost of sales (cost of goods / products sold (COGS) and cost of services): For a manufacturer, cost of sales is the expense incurred for labor, raw materials and manufacturing overheads used in the production of merchandise. Although it can be shown separately, the depreciation expense is part of cost of sales. For wholesalers and retailers, cost of sales is basically the cost of purchasing goods used for resale. For service-related businesses, cost of sales represents the cost of services rendered or the cost of revenue.
- Gross profit (gross income or gross margin): The gross profit of a business is not just the difference between net sales and cost of sales. Gross profit also provides the resources to cover all other business expenses. Obviously, the higher and more stable a company’s gross margin, the greater the potential for bottom-line results (net profit).
- Selling, general and administrative expenses: Often referred to as SG&A, these are the operational expenses of the company. Financial analysts assume that management has great control over this category of spending. The evolution of SG&A expenses as a percentage of sales is closely monitored for signs of managerial efficiency, or lack of efficiency.
- Operating result: Deducting selling and administrative expenses from the gross profit of a business produces operating income. This figure represents a company’s profits from its normal operations before any non-operating income and costs such as interest expense, taxes and special items. Income at the operational level, considered more reliable, is often used by financial analysts rather than net income as a measure of profitability.
- Interest charges: This item reflects the cost of borrowing for a business. Sometimes companies record a net figure here for interest expense and interest income on invested funds.
- Income before taxes: Another carefully monitored profitability indicator, profit before income tax expense is an important chip in the income statement. There are many techniques available to businesses to avoid or minimize taxes that affect their reported income. Since these stocks are not part of a company’s business operations, analysts may choose to use pre-tax income as a more accurate measure of the company’s profitability.
- Income taxes: As stated, the amount of income tax was not actually paid. It is an estimate or account that was created to cover the amount that a business expects to pay in taxes.
- Special items or extraordinary expenses: A variety of events may result in charges against income. They are generally identified as restructuring charges, unusual or non-recurring items and discontinued operations. These radiations are supposed to be one-off events. Investors should take these special elements into account when making year-to-year profit comparisons, as they can distort valuations.
- Net revenue (net profit or net profit): this is the net profit, which is the most commonly used indicator of a company’s profitability. Of course, if the expenses exceed the income, this item of account will be interpreted as a net loss. After the payment of any preferred dividends, net income becomes part of a company’s equity as retained earnings. Additional data is also presented for net income based on outstanding (basic) shares and potential conversion of stock options, warrants, etc. (diluted).
- Overall income: The concept of global result, relatively new, takes into account the effect of items such as foreign currency translation adjustments, minimum pension liability adjustments and unrealized gains / losses on certain investments in debt and equity. The investment community continues to focus on the net income figure. The adjustment items all relate to economic events that are beyond the control of the management of a company. Their impact is real, but they tend to equalize over an extended period.
Example of income statement
Now let’s take a look at an example of XYZ Company’s income statement for the years ended 2019 and 2020 (expenses are in brackets):
Income statement for company XYZ FY 2019 and 2020
|Net sales||1.5 million||2,000,000|
|Cost of sales||(350,000)||(375,000)|
|Operating costs (SG&A)||(235,000)||(260,000)|
|Other income (expenses)||40,000||60,000|
|Extraordinary gain (loss)||–||(15,000)|
|Net profit before taxes (income before taxes)||905,000||1,360,000|
From the example above, it can be deduced that between the years 2019 and 2020, company XYZ managed to increase its sales by around 33% while reducing its cost of sales from 23% to 19% of sales. Therefore, the gross income in 2020 has increased significantly, which is a huge advantage for the profitability of the company.
In addition, general operating expenses were kept under tight control, increasing by a modest $ 25,000. In 2019, the company’s operating expenses represented 15.7% of revenue, while in 2020 it was only 13%. This is very favorable given the strong increase in sales.
As a result, the company’s bottom line – bottom line – fell from $ 605,000 in 2019 to $ 885,000 in 2020. Positive year-over-year trends in statement items, both of income and expenses, increased the company’s profit margins (net income / net sales) from 40% to 44% – again, this is very favorable.
If you are a DIY investor, you will need to do the math. If you are using investment research data, the experts will calculate the numbers for you.
By understanding the income and expense components of the return, an investor can appreciate what makes a business profitable. In the case of XYZ Company, it experienced a significant increase in sales for the period under review and was also able to control its business expenses. It is an indicator of effective management. The one that deserves further investigation for a possible investment.
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Randall W. Luecke and David T. Réunion. “How Businesses Report Income: FASB Introduces New Rules for Comprehensive Income.” Journal of Accountancy, May 1998.