What is an Income Statement?
The underpinning of a capitalist society and economy is that Business is undertaken with the need to generate a PROFIT.
Many users are interested in knowing how well a business has done over the past month, quarter or year and the Income Statement is the Financial Statement which reflects that.
The Income Statement reports a company's profits (or losses) over a certain time period and is therefore of extreme importance.
It does so by summarizing ALL the company Revenue that has been generated minus ALL the Expenses applicable to that period resulting in a Profit or a Loss.
Business profit is the residual amount that is left over after deducting the expenses from the revenue.
The Income Statement can be summarized easily using the following equation,
TOTAL INCOME - TOTAL EXPENSES = NET INCOME (OR LOSS)
In it's purest form, the Income Statement would look like below.
However, Accountants add layers of information such as Gross Profit and Operating Profit in betweenwhich are helpful to the readers of an Income Statement and changes the above format a bit (There is more on this coming up).
In this article, we first break down the landscape of the Income Statement to help you understand each aspect of the Income Statement such as Revenues, Expenses, Gross Profit etc.
Once you understand each individual part of the Income Statement, you will see how the pieces fit together as a whole which will help you read Income Statements by yourself in the future.
Why does the Income Statement Matter?
Breakdown of the Income Statement
In theory, the Income Statement is perhaps the easiest of the three Financial Statements to understand.
It simply comes down to the Income a business earns minus the expenses it pays to run the business.
If the money a Business makes (Income) exceeds the Expenses of the business during the Financial period under consideration, the company has made a Profit!
Cha - ching!
If the money a Business makes is not enough to meet the Expenses of the Business during the Financial Period- The company has made a Loss!
If you understand this point, you have understood the Income Statement.
Since the details of the Income and Expenses are important to stakeholders, accountants typically break these down further.
"Why are the details of Income and Expenses important?"
Because a break up of these items allow users to notice outliers and trends in Revenue and Expense Items.
For example, the owner might notice that the Utility Expenses have been disproportionately higher this year compared to the last and investigate that further saving him money.
Or, a manager may notice a trend of reduction in profits year on year and investigate that further.
You can see the snapshot of a typical Income Statement for a small business below.
SUPERPOWER INC. Income Statement For the Year Ended Dec 31, 20XX | ||
|---|---|---|
Revenue | $30,000 | |
Cost of Goods Sold | ($18,000) | |
Gross Profit | $12,000 | |
Operating Expenses | ||
Rent | $5,000 | |
Advertising Expense | $2,000 | |
Total Operating Expenses | ($7,000) | |
Net Income | $5,000 | |
Typically, there are three sources where a Company can earn money from
1. Sales
Sales is the primary source of money generated in a Business.
The term Revenue, Salesand Income are used interchangeably and refer to the total amount earned from the Business from all its income sources.
It is the money a business makes from it's core operations.
For Example, a Car Manufacturer selling a Car would be classified as a Sale in the Income Statement.
The Income Statement reflects the Total Sales made from selling its goods or services to its customers over a particular period (The period is defined on top of the Income Statement).
Sales are also referred to as 'Revenue' or 'Turnover'.
2. Income from Secondary activities.
This is the income a company makes from activities that are not the main activities of the Business.
For Example, this could involve making interest income on deposits, renting out unused space etc.
3. Gains
Another way in which businesses make money is through Gains.
Gains also typically arise from non - core activities of the business.
For Example, a gain may be due to the increase in value of a company asset or property.
They could also be made due to the settlement of a lawsuit.
Cost of Goods Sold
Before a company can sell a product, it spends money on buying that product.
Cost of Goods Sold (or COGS for short) involves ALL the costs that a company undertakes to produce or purchase the goods that it sells.
These Costs typically include the Cost to purchase items, Freight Costs to transport items, custom duties etc.
The Cost of Goods Sold amount is reported consolidated in the balance sheet which means that typically, readers of the company Financial Statements do not see the breakup of the Cost of Goods Sold as the detailed breakup of COGS is only meant for Company Management.
Gross Profit
The Gross Profit Line in the Income Statement is simply a calculation of the Revenue minus Cost of Goods Sold.
Basically, this number reflects the difference between what a company pays for the inventory and the price at which it sells its inventory.
Gross Profit is considered the preliminary or "first line" measure of profit before other expenses are taken into account.
Managers, Investors and other interested parties closely watch the trend in Gross Profit as it indicates the effectiveness of the companies pricing and purchasing policies.
Gross Profit is also often referred to as Gross Margin.
Selling, General and Administrative Expenses
The selling, general and administrative expense (also known as SG&A) is comprised of all operating costs of a business that are not included in the cost of goods sold.
Some of the costs that may be included in the S G & A Classification include
- Advertising and Sales Promotion
- Rent Expenses
- Utilities Expenses
- Accounting and Legal Expenses
- Depreciation
- Other costs that involve operating the business to support the sales process.
Important
Interest Expenses and Finance Costs come after and are not included in the S, G and A Expenses.
It is upto the company management's discretion how much of the breakup of S, G & A they would like to give in the Income Statements.
S, G & A Costs can vary quite a bit from industry to industry and even from business to business.
Investors look to SG&A as a measure of how efficiently a company is using its money.
Technical Stuff
Operating Profits
Typically, the Gross Profit minus the Operating Expenses of a business equal the Operating Profit.
The Operating Profit may not be explicitly stated in the Income Statement but is often calculated by readers since it quantifies the profit generated from the CORE OPERATIONS of the business.
Interest Expenses
Everybody owes something to someone and companies are no different.
Interest Expenses is a non operating expense which arises from the borrowings of a company and could be from bonds, loans, overdraft facilities etc.
Readers of Financial Statements pay close attention to the debts on a business since the amount of interest expense has a direct bearing on company profitability.
Tax Expenses
The Tax Expense line in the Income Statement is the cumulative expenses that a company has paid to the federal, state and local governments.
Within the confines of the law, most companies use several accounting practices to minimize their tax burden and improve profits.
However, no one can completely escape the tax man and companies are no different.
Net Profit (or Loss)
Arguably, the most important number in the Income Statement - The Net Profit represents the net results after ALL expenses have been deducted from Revenue.
Often referred to as "the bottom line" - the Net Profit figure is closely watched and any major shifts in Net Profit are closely scrutinized by readers.
Caution
Net Profit does not mean Cash in the Bank!
Many people assume that Net Profit reported by a Business produces cash of the same amount but that's not the case.
The difference in Net Profit on the Income Statement and the actual Cash received by the Business arises for two reasons.
REASON # 1. Credit plays a very important role in the life of most businesses.
Due to Credit transactions being prevalent in many industries, most Businesses may sell a product or service now but take the cash for it later.
Similarly, businesses also utilize services and incur expenses now and pay for them later (think of an electricity bill as an example of a Business utilizing a service now and paying later).
Accountants have devised a system of Accounting called Accrual Accounting to measure the impact of such credit transactions on a Business.
At this stage of your learning, it is important for you to note that the usage of accrual accounting impacts an Income Statement and does not make the Net Profit number straightforward and there is usually a difference between the Net Profit number and the Cash Received.
REASON # 2. The Expenses listed on the Balance Sheet include Non Cash Expenses such as depreciation, amortization and other non cash adjustments which also reduce the Net Profit amount.
By now if your wondering, as a newbie to the accounting world - how in the world would you really (and easily) know the Cash coming and out of the Business ?
Well, don't worry.
Accountants have us covered.
To show the real cash movements in a Business, accountants also prepare what is called a Cash Flow Statement which summarizes all the Cash movements in a Business.
Conclusion
The Income Statement is a Financial Statement that summarizes the Revenue and Expenses of a Business during a particular period and shows if the Business has made a Profit or a Loss.
The Net Profit of a Business does not equal cash in the bank. This is mainly due to two reasons. The First being that most businesses follow what is called Accrual Accounting which is different from cash accounting.
The Second reason is that The Net Profit number is arrived at by deducting depreciation, amortization and other non cash adjustments which are all non cash expenses.
If you are new to accounting the next thing I would read about would be the Balance Sheet and the Cash Flow Statement.
If you want to learn accounting with a dash of humor and fun, check out our video course.
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Tax and accounting rules and information change regularly. Therefore, the information available via this website and courses should not be considered current, complete or exhaustive, nor should you rely on such information for a particular course of conduct for an accounting or tax scenario. While the concepts discussed herein are intended to help business owners understand general accounting concepts, always speak with a CPA regarding your particular financial situation. The answer to certain tax and accounting issues is often highly dependent on the fact situation presented and your overall financial status.
