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).
Aspect
Explanation
Statement Overview
An Income Statement, also known as a Profit and Loss (P&L) Statement, is a financial statement that provides a summary of a company’s revenues, expenses, and profits (or losses) over a specific period, typically a quarter or fiscal year. It is one of the key financial statements used by businesses to assess their financial performance and profitability. The Income Statement follows a structured format, starting with revenues, deducting various expenses, and arriving at the net income or net loss. It offers valuable insights into a company’s ability to generate profit from its operations.
Components
The Income Statement consists of several key components: 1. Revenue: This is the total income generated by the company from its primary operations, such as sales of goods or services. 2. Cost of Goods Sold (COGS): These are the direct costs associated with producing the goods or services sold, including materials, labor, and manufacturing expenses. 3. Gross Profit: Gross profit is calculated by subtracting COGS from revenue and represents the profit from core business activities. 4. Operating Expenses: These include various expenses related to the company’s day-to-day operations, such as salaries, rent, utilities, marketing, and administrative costs. 5. Operating Income (Operating Profit): It is derived by subtracting operating expenses from gross profit, indicating the profit from core operations. 6. Other Income and Expenses: This section includes non-operating items like interest income, interest expenses, and gains or losses from investments or asset sales. 7. Net Income (Net Profit): The bottom line of the Income Statement, net income is the final profit figure after accounting for all expenses and taxes. If expenses exceed revenue, it results in a net loss.
Purpose and Analysis
The primary purpose of the Income Statement is to assess a company’s profitability over a specific period. Key points for analysis include: 1. Revenue Trends: Examining trends in revenue growth or decline. 2. Gross Profit Margin: Calculating the percentage of gross profit relative to revenue to assess the efficiency of core operations. 3. Operating Expenses: Evaluating the control of operating expenses relative to revenue. 4. Net Profit: Assessing the final profitability of the company after all expenses. 5. Comparisons: Comparing Income Statements over multiple periods or against industry benchmarks to identify areas of improvement or concern.
Interconnected Financial Statements
The Income Statement is closely linked to other financial statements: 1. Balance Sheet: Net income from the Income Statement flows into the equity section of the Balance Sheet, affecting the owner’s equity. 2. Cash Flow Statement: Components of the Income Statement, such as net income and depreciation, influence the Cash Flow Statement, particularly the operating activities section.
Formats
There are two common formats for presenting the Income Statement: 1. Single-Step Format: This format lists all revenues and then deducts all expenses in a single step to calculate net income. It is straightforward and suitable for small businesses. 2. Multi-Step Format: In this format, the Income Statement includes multiple sections, such as gross profit, operating income, and non-operating income. It provides a more detailed view of the company’s financial performance and is often used by larger corporations.
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.
Key Highlights
Income Statement: An income statement, also known as a Profit and Loss (P&L) statement, shows the revenues and costs incurred by a company over a specific period. It helps determine whether a company is running at a profit or a loss.
Purpose of Income Statement: The income statement answers questions like whether the company is generating returns and if its revenues cover expenses.
Components of Income Statement:
Revenue: The income generated from sales or services.
Expenses: The costs incurred by the company.
Profit/Loss: The result of subtracting expenses from revenue.
Presentation Methods: There are different ways to present the income statement:
Negative Costs: Costs reported as negative numbers compared to revenue.
Gross Profit: All items shown with a positive sign, with costs subtracted from revenue to obtain gross profit.
Revenue Breakdown:
Operating Revenue: Generated by core business operations (e.g., selling products).
Non-Operating Revenue: Generated by sources outside the core business (e.g., interest income).
Expense Categories:
Cost of Goods Sold (COGS): Costs directly associated with producing goods.
Operating Expenses: Costs related to business operations (e.g., salaries, advertising).
Non-Operating Expenses: Costs outside of core operations (e.g., interest expenses).
Profitability Metrics:
Gross Profit: Revenue minus COGS, indicating operational efficiency.
Operating Profit: Gross profit minus operating expenses.
Net Income: Revenue minus all expenses, showing overall profitability.
Profitability vs. Cash: Profitability in the income statement does not always correlate with cash on hand, especially if using the accrual accounting method.
Real-World Application:
Profitability Framework: A framework to quickly analyze a company’s profitability by assessing revenues and costs. It helps identify where profitability issues arise and strategize accordingly.
Connecting the Dots: The income statement assesses the viability of a business model, while cash flow statements provide insights into liquidity.
Use of Knowledge: Understanding income statements allows for the analysis of real-world scenarios, identifying profitability problems, and strategizing solutions.
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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.
