If you want to get an idea of how a company performs, the income statement may just be the one you’re looking for.
Also known as the profit and loss statement, it gives you information on how a company earns revenue and the corresponding cost and expenses incurred to arrive at such revenue.
The contents of an income statement will vary from company to company, although you may be able to find some similar looking ones especially if they’re from the same industry.
Furthermore, whether the company is employing the cash accounting method or the accrual accounting method, the income statement’s end goal is to provide you with information on a company’s profitability.
The Income Statement: What is it?
The income statement is a financial statement that focuses on a company’s ability to generate profit.
It is one of the three main financial statements, the other two being the balance sheet, and the cash flow statement.
It can be used to arrive at significant ratios such as the gross profit ratio which gauges the efficiency of a business computed by dividing the gross profit (revenue minus cost) over total revenue.
An income statement should be able to provide you with enough information to gauge a company’s profitability over a specific point in time.
If you just want to skim over the income statement, just look at the very bottom figure (usually the net income) and see if it’s positive or negative.
A positive figure would usually tell you that the company is doing well for that period, while a negative figure would indicate the opposite.
What’s in an Income Statement?
Before we delve further into the income statement, we must first consider whether a company is employing the cash accounting method or the accrual accounting method.
These two accounting methods might arrive at different figures due to the difference in how each method accounts for transactions.
To illustrate this, let’s say customer A decided to employ your company’s services in December.
Customer A paid for such service in advance.
However, due to the volume of transactions that you’re having, your company was only able to serve customer A in January of the next year.
Now if you prepare your financial statements ‘as of December 31, XXXX’, can you see how the two different accounting methods would arrive at a different net income?
For the cash accounting method, you would record revenue when you receive payment.
For the accrual accounting method, you would only record revenue when you earn it (in this case, when your company rendered its services).
Thus, for this example, expect the net income for the cash accounting method to be higher than that of the accrual accounting method.
Now with that out of the way, let’s discuss the contents of an income statement.
It will vary from company to company, seeing as how a company produces income and incur expenses will be dependent on the company’s nature and operations.
However, you will often see generic line items that appear in any income statement.
These common line items include the following:
This refers to the revenue/sales of a company.
Its figure would depend on how it is recorded.
For the cash accounting method, revenue is recorded whenever cash is received, regardless of whether sales had been made or not, or when services have been rendered.
For the accrual accounting method, revenue is recorded when sales have been made, or when services have been rendered regardless of whether payment is received or not.
The revenue/sales account is usually the first item to be listed in an income statement.
A company may have multiple sources of revenue, to which they can be displayed separately in the income statement.
For example, a company may offer both products and services. In this case, a company may list “Sales Revenue”, and “Service Revenue” in its income statement as items under the revenue account.
Cost of Goods Sold/Cost of Sales
This refers to the costs that can be directly attributed to revenue.
For companies that are engaged in the sale of products, this line item will be Cost of Goods Sold.
For those that are in the service industry, this line item will be Cost of Sales.
Examples of costs that can be directly attributed to revenue are direct labor, materials, cost of products sold, and an allocation of other expenses (e.g. depreciation).
Gross profit is the figure that you would arrive at after subtracting the costs from revenue.
It represents a company’s profit for every sale made.
A well-performing company will always have a positive gross profit.
It just proves that a company is efficient in managing its costs.
It wouldn’t be a good picture if a company’s costs are higher than its revenue afterall.
With these first three line items, we can compute a company’s gross profit ratio.
For example, company A has a revenue of $1,000, and a cost of sales of $650, resulting in a gross profit of $350.
Using the formula for computing gross profit ratio, we arrive at 0.35 or 35%.
This means that for every $1 of revenue, that company earns $0.35 in gross profit.
We can then compare this ratio to previous period income statements to see if a company is performing better or worse.
Or we can compare it to companies in the same industry to know if the company is performing within industry standards.
Other Revenue (Non-Operating Revenue)
Some companies generate revenue outside of their primary operations, such as when a company not primarily engaged in the renting industry earns rent income from leasing a part of its property.
Or when a company receives payment due to an advertisement display placed on its property.
It’s best to separately list these items from the revenue/sales so that we can easily get a more accurate picture of a company’s earnings from operations.
Running a company goes hand in hand with incurring expenses.
The Operating Expenses line-item includes expenses that cannot be directly attributed to revenue such as rent, utility, general and administrative expenses, salaries and wages, etc.
These are expenses that a company usually incur for as long as it continues its operations.
Depreciation and Amortization
When a company acquires a long-term asset such as machinery and equipment, it does not record the whole cost of the asset as an expense immediately, but rather spreads it over the expected life of the asset.
Depreciation applies to tangible assets such as machinery, equipment, other fixed assets.
Amortization is for intangible assets such as software, patent, goodwill.
Do note that depreciation/amortization is not accounted for in the cash accounting method as it is a non-cash transaction.
Rather the whole amount of the asset is recognized as expense outright.
Also known as other income, gains refer to income gained from other non-business activities, such as the sale of a long-term asset (e.g. machinery, equipment) for more than its book value.
Gains usually refer to net income generated from one-time non-business activities.
While gains refer to a positive outcome from other non-business activities, losses refer to the opposite.
Losses arise when a company loses money or value, such as when it sells its long-term asset for less than its book value.
Aside from that, losses can also refer to expenses outside of normal operations, such as losses due to natural disasters, or expenses incurred towards lawsuits.
Net Income is the figure you’d arrive at after adding all revenue, gains, and subtract all costs, expenses (including taxes) and losses.
Simply put, it is the net earnings of a company from its business and non-business activities.
Net income is what goes to a company’s retained earnings, after deducting dividends (if there are any).
A company may have a positive gross profit and yet have a negative net income.
It may be because the company may haven’t been able to generate enough revenue or maybe the company is incurring more expenses than what is necessary.
Single-Step Income Statement vs Multiple-Step Income Statement
A company may structure its income statement according to the ‘single-step income statement’ or ‘multi-step income statement’ structures.
Of the two, the single-step income statement is the simpler and easier one to create.
Single-step income statement
The single-step income statement is structured according to the following formula:
Net Income = (Revenues + Gains) – (Expenses + Losses)
To further understand this equation, let’s illustrate it with an example:
As can be seen from the above sample income statement, the items are divided into four categories:
- Losses, which follows the single-step income statement structure.
XYZ company earned a total of $44,500 from its sales of goods and rendered services.
To arrive at such revenue, XYZ had to incur a total expense of $36,060.
During the year, the company decided to sell one of its pieces of equipment which resulted in a gain of $80.
Unfortunately, the company suffered unavoidable losses due to fire which amounted to $170.
All in all, XYZ reported a net income of $8,350 for the year ended December 31, 2020.
Simple isn’t it?
This type of income statement is usually used by small businesses and sole proprietors that don’t have many different sources of revenue.
Multi-Step Income Statement
The multi-step income statement, as its name implies, follows a structure where it uses multiple steps instead of one.
Revenue and expenses from operations are separated from non-operating revenue and expenses under this type of income statement.
It offers much more details than the single-step income statement.
The multi-step income statement is usually used by large and complex companies that have several revenue sources such as multi-industry or multi-brand companies.
Listed companies are required by law to create multi-step income statements as they need to disclose more details in their financial reports which the single-step income statement can’t provide.
It can come in many shapes, but the multi-step income statement generally follows the structure: gross (revenue, cost of sales, gross profit/margin), operating (operating expenses, operating income), pre-tax (income after operating and non-operating expenses, gains, and losses), after-tax (income after all expenses and taxes).
This structure can help us gauge the efficiency of a business. For example, if a company has a high gross profit relative to its revenue, it must mean that they are cost-efficient in their sales.
However, if a company has a high gross profit, but a very low or even negative operating income, it might mean that a company is not managing its operating expenses that well.
To further illustrate this, here is a sample of a multi-step income statement:
The above example is a comparative income statement of Apple Inc. for the years ended September 29, 2017, 2018, and 2019.
For this article, we’ll focus on the year ended September 29, 2019. As seen, it follows the gross, operating, pre-tax, after-tax structure.
For the fiscal year ended September 2019, Apple Inc. was able to generate total revenue of $260,174,000 (after returns, discounts, and allowances) from its sales of products and services.
Costs that can be directly attributed to these sales amounted to $161,782,000, which resulted in them having a gross margin of $98,392,000.
From these, we can derive a gross profit ratio of 0.38, which means that for every $1 of sale, Apple Inc. earns a gross margin of $0.38.
Apple Inc. incurred operating expenses of $34,462,000. If we subtract that figure from the gross margin, we will arrive at an operating income of $63,930,000.
This figure represents the income that Apple Inc. generated from its operations.
Moving down further we see that they have other income (non-operating income) of $1,807,000.
Adding this to the operating income will result in a pre-tax income of $65,737,000.
This figure represents income generated from all sources, be it from operations or non-operations.
And finally, we arrive at the taxes. For the above income statement, Apple Inc. included the line-item “provision for income taxes” with an amount of $10,481,000.
It is the amount of income taxes that Apple Inc. expects to pay for the year.
Subtracting it from the pre-tax income will result in a net income of $55,256,00.
This is the amount that will go to Apple Inc’s retained earnings after deducting dividends.
The above income statement listed more items below the net income line item, namely “earnings per share”.
This is just one of the financial ratios that we can derive from an income statement.
It shows us how much a single stock earns for its shareholder.
We will delve into this further when we discuss financial ratios.
Income statements and their uses
The main purpose of an income statement is to provide information regarding a company’s ability to generate profit.
From it, we can also derive how a company handles its costs and expenses.
It can also provide information that can be compared across businesses and industries, such as the gross profit/margin.
It’s also a good tool for internal purposes, especially if prepared with departments or segments in mind.
Or maybe even products.
For example, if a company prepares its income statements where it segregates the sales of its products into different line items of revenue, along with the costs attributable to those products, we can see which product is the most cost-efficient.
Management can use income statements to make decisions such as expanding to a new untapped market, the discontinuation of a product, where the company can cut costs.
Competitors can use them for comparison, to gauge whether they are as profitable, etc. Creditors may find limited use from an income statement as they are more concerned about a company’s ability to pay, but knowing if a company is profitable won’t hurt them.
Analysts can use it to arrive at relevant financial ratios, and from there can infer whether a company can stay profitable in the future, or even analyze trends in regards to its profit generation.
As for the business owner, it is there to inform whether your business is profitable or not.
It can also inform you on whether you’re managing your expenses well, or maybe you’re going overboard with it.
An income statement is just a very useful tool that provides insights into the many aspects of business.
It can show you an idea of the company’s operations, its efficiency in generating profits, the areas where you can improve upon in terms of profits, and whether the company is performing according to industry standards.
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