LEARNING OBJECTIVES:
Once you’ve finished reading this article, you should be able to:
- Explain what an income statement is, its purpose, and its importance in analyzing the financial condition of a business.
- Communicate the various components of the income statement.
An Income Statement (also referred to as a Profit of Loss Statement “P&L”) is one of the three primary financial reports used for analyzing the financial condition of a business. The income statement summarizes sales revenue and expenses over a fixed period of time – the primary purpose being to present the profit performance of the business.
The top line of an income statement is the total amount of proceeds or gross income from your sales – it is referred to as sales revenue. The bottom line on an income statement is called net income and is the final profit after all expenses are deducted from sales revenue.
The income statement is designed to be read from top to bottom, with each line item representing a deduction of one or more expenses. The steps for reading the report are:
- The first line deducts the cost of goods sold (“COGs”), your products, from the sales revenue of goods sold, which gives us our gross margin;
- Next, operating expenses (every expense other than COGs, depreciation, interest, & taxes) are deducted from gross margin, giving us earnings before interest and income tax (also called operating earnings);
- Next, interest expenses on debt is deducted; and
- Lastly, deduct income tax expense which gives you net income.
EXAMPLE
Learning how to read and analyze an income statement is essential for determining the financial performance of a business, predicting its future performance, and gauging its ability to generate future cash flows. Once you have this skill under your belt, you are will on your way to making better and more informed business or investment decisions.
Key Terms
Income Statement: Summarizes sales revenue and expenses for a period of time.
Financial Reports: Formal records of the financial activities and position of a business Relevant financial information is presented in a structured manner and in a form which is easy to understand.
Sales Revenue: The total amount received or to be received from the sales of products (and/or services) to customers during the period.
Net Income: The final profit after all expenses are deducted from sales revenue.
Cost of Goods Sold (COGs): The total cost of goods (products) sold to customers during the period.
Gross Margin: Sales Revenue – COGs = Gross Margin
Operating Expenses: Every expense other than the COGs, depreciation, interest, and income tax.
Operating Earnings: Gross Margin – Operating Expenses = Operating Earnings
Depreciation Expense: The portion of original costs of long-term assets that is recorded to expense in one period.
Interest Expense: The amount of interest on debt for the period.
Income Tax Expense: The total amount due to the government on the amount of taxable income of the business during the period.
