The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at a fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at a profit or loss (also called the P&L statement).
Income statement explained
When you look at your P&L, it will answer questions such as:
Is the company making any return?
Is the organization making enough revenues to cover for its expenses?
Let us see a real Income Statement below:
The Income Statement or Profit and Loss is a financial statement that shows the Profit or Loss incurred by an organization in a certain period of time. In this example we saw the P&L for the year.
In addition, this statement can be produced for the year, quarter, month. In regard to reporting purposes, instead, the P&L can be published every three or six months.
In the above example the P&L shows the Income as positive and the costs as negative. There are several methods to present the P&L:
On one hand, you can use the method where costs are reported already as negative numbers compared with revenues.
On the other hand, you can use another method, where all the items are shown with a positive sign and then you just subtract the costs from the revenues to obtain the Gross Profit.
Whether you decide to use the first or second method it is irrelevant, however what matters is consistency. In fact, if you use this method for your income statement you must use it across all the other financial statements you are building, to avoid confusion.
Revenue
The first item of the Income Statement is Revenue. Imagine you have a bakery that sells donuts at $1 each and you sold 100 donuts, your total revenue for the day will be $100. Even though some customers paid with credit cards and the cash on your bank account will be deposited within thirty days you will still recognize $100 in Revenue.
How can we break down the Revenue? See the diagram below:
The two main sources of Income are coming from: core business operations or outside core business operations. Furthermore, we can identify the former as Operating and the latter as Non-Operating revenue.
Operating Revenue
They are generated by the sales coming from the core product an organization produces.
Example: Imagine owning a Pizza Store. The income generated by selling pizzas will be considered an Operating Revenue. In the example, the Operating Revenue formula is: price per unit times Units Sold (Volume). Indeed, if the price for your pizza is at $1 per unit, and 100 pizzas were sold, your revenue will be $100.
Non-Operating Revenue.
They are generated by sales coming from other sources.
Example: Imagine your Pizza Store business is going pretty well and you are generating cash in excess that can be invested in short term instruments such as bonds. Later, you go to the bank and buy $1,000 of T-Bills. This is a short-term debt obligation backed by U.S. government with a maturity of less than one year. Your T-Bills are due in six months, after that you will receive a simple interest of 2% annually or $10. The $10 you receive after six months is Interest Income or non-operating revenue, also described as incidental or peripheral income. However, on your balance sheet the interest income will be reported after the interest expense, almost like an offsetting. It is more accurate to report the interest income together with the other non-operating expenses. In this way the income generated by interests will not distort our Gross Income.
Indeed, the Gross Income divided by sales gives us the gross margins, which is a metric of operational efficiency.
Expense
The other main component of the income statement is cost/expense. There are many costs incurred by an organization. That is why most of the time can be very tricky to categorize them. In addition, cost categorization is crucial for any business, since they represent a big piece of the pie of any organization’s profits. If not managed properly can lead to big issues, ultimately to bankruptcy. In fact, there are several methods that can be used to classify costs, such as: Operating vs. Non-operating, Direct vs. Indirect, Variable vs. Fixed. It all depends by the perspective from which you look at them. Each one of these methodologies has the purpose of better understanding the cost structure of the organization. It is called “cost accounting”.
There are several types of expenses classified in the income statement. Let’s take into account three main categories of costs for reporting purposes:
Cost of Goods Sold (COGS)
Operating Expenses
Non Operating Expenses
Cost of Goods Sold (COGS)
This is the cost incurred to generate the revenue for the period in consideration. For example, a company who produces Smart Phones will have actual costs of production.
These costs, such as: Raw Materials, Wages associated to manufacturing, Overhead costs of running the factories, will be all considered COGS. These costs can be defined as direct costs as well.
After subtracting COGS from Revenue we get the Gross Profit.
This metric can be pretty useful in assessing the profitability and efficiency of the business when it comes to the manufacturing process.
The gross margin is a financial ratio metric, which helps assess the profitability of a business and also its operational efficiency. Indeed, as gross margins take into account cost of goods sold (the cost incurred to deliver the software to the customer) it’s a measure to assess the value of a business.
Operating Expenses
These are all the costs not included in the COGS.
These costs are related to the operations of the business, such as: Advertising, salaries and wages, phone and Internet. However, they are not incurred to generate sales or at least in many cases it is hard to track the effect of this cost over the additional sale incurred by the organization.
After subtracting the operating expenses from Gross Profit we get the Operating Profit. This metric is useful as well to assess the profitability and efficiency of the business when it comes to the overall operations.
Non-Operating Expenses
The remaining costs not included in the previous categories.
They are incurred outside the business operations.
Example: Imagine you own a Coffee Shop. Suddenly your sales plunge, you still need money to finance the operations, since the alternative would be closing the business. Therefore, you go to the bank and ask for a short-term loan of $4,000 that will be repaid in six months. The loan will carry a simple interest of 5% annually. Therefore, at the end of the six months, after paying the principle, you will eventually pay for the interest of $100. The money paid as interest will show under the Income Statement as interest expense for that period.
The revenue minus the operating and non-operating expenses for the period, give us the Net Income. This metric is very important to assess the overall efficiency and profitability of the business. We will see it in detail in Chapter
Connecting the dots: Net profits explained
Whichever profits are shown on your income statement they do not tell you anything about cash.
It might be a shocking truth for who is new to Accounting. Indeed, this is not always true, especially if we operate under the cash basis, instead of the accrual basis principle.
On the other hand, most companies operate under the accrual principle. Thus, while the income statement and its bottom line, the net profits will tell us the story on whether the business model is viable.
It won’t tell us the story on whether the business is liquid (for that we’ll need the cash flow statement).
Example: Imagine you own a bakery that sold $1,000 in chocolate cakes in the first month. This event does not imply that you have $1,000 on your bank account. In fact, most of the time customers pay within 60/90 days. Therefore, half was received in cash; the other half was bought on credit. Thus, the first half ($500) is an actual cash inflow, the other half ($500), instead will be reported on your Balance Sheet. The transaction can be recorded like the following:
Imagine now, the bakery incurred $500 of expenses in that same period for raw materials; Half is purchased on account, and half paid on account. This implies a cash outflows for $250. The other half will show on the Balance Sheet, under Accounts Payable (Current Liability’s Section). See below:
Profitability framework to quickly analyze real scenarios
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.
Now that you know how an income statement works, you can use this knowledge to analyze real-world scenarios. Perhaps, you can understand when a profitability problem arises, where it’s coming from and with the framework above and this profitability framework guide you can identify the specific problems and address them.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
