An income statement is one of the three main financial statements used to evaluate the financial performance of a company. Also known as the Profit and Loss (P&L) statement, the income statement shows a company’s income, expenses, gains, and losses over a specific period of time. In this article, we are going to take a closer look at what is an income statement and how it is used by businesses and investors alike.
Highlights/ Key Takeaways
- An income statement is one of the three main financial statements in accounting, which are used for reporting the financial performance of a company.
- The income statement summarizes the revenue, gains, expenses, and losses of a company over a specific period of time. It is also called the Profit and Loss statement.
- Income statements are often prepared on a monthly, quarterly, or annual basis, showing the company’s operations and financial trends over time.
- The statement can be used by internal and external stakeholders alike to evaluate the company’s financial health, conduct competitive analysis, and provide insights into the company’s financial activities.
What Is an Income Statement?
An income statement, also known as the “profit and loss statement” or the “statement of earnings”, is one of the three financial statements used in accounting to track the financial performance of a company. It is often used along the balance sheet and the cash flow statement, providing valuable insights into a company’s operations, efficiency, and overall financial position.
The income statement includes business revenue and gains, minus its losses and expenses, showing how profitable the business was over a given period of time. Companies often produce monthly, quarterly, or yearly income statements, which are used by banks and investors to evaluate the company’s profitability.
“The income statement includes business revenue and gains, minus its losses and expenses, showing how profitable the business was over a given period of time.”
Why Is the Income Statement Important?
By outlining a company’s expenses, income, gains, and losses, the income statement allows one to calculate the net profit or loss of the company during the reporting period. This information, in turn, allows business owners to make important decisions to ensure the financial success of the company.
Here is why regularly preparing and reviewing income statements is important for any small business:
- Frequent reports. While other types of financial statements are prepared annually, income statements are typically generated quarterly or even monthly. This allows investors and business owners to closely monitor the performance of the company, fix small business problems, and make important decisions on time.
- Overall analysis of the company. The income statement provides investors with a quick overview of the company they may be considering investing in. Banks and other lenders can also use this information to decide whether to extend a loan to the business.
- Expenses breakdown. The income statement highlights the expenses incurred by the company, enabling business owners to determine which business areas were over or under the budget. Understanding business expenditures in detail and adjusting them when needed is critical for any growing business, which may often find its expenses soaring.
What’s the Purpose of an Income Statement?
The main purpose of an income statement is to summarize a company’s financial performance over a certain period of time. The statement shows the financial side of a business’s operations, providing insights into the company’s internal activities.
Simply put, the income statement is used by business owners, accountants, and investors, to understand how profitable (or not) a particular company was between two points in time.
What’s the Income Statement Formula?
When preparing an income statement, businesses have two reporting options to choose from: a single-step or a multi-step income statement. Both types of income statements report on the revenues, expenses, and subsequent profit or loss of a business over a chosen period of time. The format of the income statement will depend on the type of business in question and the ultimate purpose of the statement.
Single-Step Income Statement Formula
A single-step income statement presents a simple report outlining a business’s profit, which uses a single equation to determine the net income:
Revenue - Expenses = Net Income
Most of the time, revenue and expenses will be single-line items. For example, this means that “revenue” will not separate sales from the Cost of Goods Sold.
Multi-Step Income Statement Formula
On the other hand, a multi-step income statement separates operational revenues and expenses from non-operational ones. Calculating net income with this type of income statement involves the following three-step process:
- Sales - Cost of Goods Sold = Gross Profit
- Gross Profit - Operating Expenses = Operating Income
- Operating Income +- Non-Operating Items = Net Income
While the multi-step income statement formula is more complex, the final value provides more detailed information about a company’s financial situation.
Who Uses an Income Statement?
Income statements are often reviewed by internal business management and external stakeholders alike.
How Income Statements Are Used Internally
When used internally, the income statement can help business owners to evaluate the profitability of their company, the factors involved, and how the profits can be increased going forward. As such, they can decide whether they can generate more profits by decreasing expenses, increasing revenues, or both.
The income statement also demonstrates the effectiveness of new business strategies implemented at the beginning of the reporting period. By seeing how a particular strategy has affected business profitability, the management can come up with the best solutions to yield more profit in the future. For example, the management team may decide to expand the production capacity, extend product offerings to new geographies, or shut down a non-profitable department or a product line.
How Income Statements Are Used Externally
Investors also use income statements to better understand the operations, efficiency, and performance of a company they are considering investing in. Similarly, banks and other lenders often review all three financial statements of a company in question to determine whether to approve their loan application and which rates and terms to offer.
Business competitors may also use income statements to better understand the success parameters and focus areas of more profitable players within the industry. For example, upon reviewing a competitor’s income statement, business management may decide to increase R&D spending.
“When used internally, the income statement can help business owners to evaluate the profitability of their company, the factors involved, and how the profits can be increased going forward.”
What Are the Major Components of an Income Statement?
The exact components outlined in the income statement can vary slightly from company to company, depending on the specific industry and the type of business operations. Nevertheless, several major components can be found in every income statement. These include:
- Sales Revenue. The Sales Revenue value appears at the top of the income statement, describing the company’s total revenue from sales or services.
- Cost of Goods Sold (COGS). The COGS line aggregates all the direct costs incurred while producing and selling products to generate revenue. Such costs can include materials, parts, labor, plus depreciation.
- Gross Profit. Gross Profit can be calculated by subtracting the COGS value from Sales Revenue.
- Marketing, Advertising, and Promotion Expenses. This line summarizes all the expenses associated with marketing, advertising, and promoting goods or services.
- Selling, General, and Administrative (SG&A) Expenses. Such expenses include all the indirect costs associated with running a business, such as rent and office expenses, wages and salaries, travel expenses, insurance, and sometimes depreciation and amortization.
- EBITDA. EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. While it is not always included on an income statement, it is a common accounting metric calculated by subtracting SG&A expenses (except depreciation and amortization) from gross profit.
- Depreciation & Amortization Expenses. The concepts of depreciation and amortization are used by accountants to spread out the cost of fixed or intangible assets respectively over their useful lifetime.
- Operating Income (or EBIT). Earnings Before Interest and Taxes, or EBIT, represents the earnings of a company from its regular operations, before any non-operating expenses, interest, and taxes are subtracted from revenue.
- Interest. Often, interest income and interest expense will be included on separate lines of the income statement. This allows differentiating between EBIT and EBT.
- Other Expenses. Many times, companies incur expenses unique to their industry. These may include impairment charges, R&D, stock-based compensation, losses or gains on the sale of an investment, foreign exchange impacts, and more.
- EBT (Pre-Tax Income). Earnings Before Tax, or pre-tax income, can be calculated as operating income minus interest expense.
- Income Taxes. This is the value of the relevant taxes applied to the pre-tax income. The Income Taxes line includes both current and future taxes.
- Net Income. Finally, Net Income is calculated by subtracting income taxes from EBD.
Income Statement vs Balance Sheet: How Are They Different?
An income statement and a balance sheet are both important financial statements used to evaluate the overall financial position of a company. However, there are several notable differences between the two:
- Timing. The income statement describes a company’s financial situation over a certain period of time. The balance sheet, on the other hand, captures a company’s financial position at a specific point in time.
- Items reported. The income statement reports revenues and expenses that result in a net profit or loss, including any tax expenses. The balance sheet reports a company’s assets, liabilities, and equity, including unpaid tax liabilities.
- Metrics. The line values included in the income statement can be compared to sales to determine the net income percentage, the operating income percentage, and the gross margin percentage. The values included on the balance sheet can be compared to each other to determine the liquidity of a business.
- Internal uses. The income statement is used by business management to evaluate the company’s performance and identify any financial or operational issues that need to be addressed. The balance sheet is used to determine whether a company has sufficient liquidity to meet its obligations.
- External uses. Creditors and lenders use the income statement to determine whether a business is generating enough profit to cover its liabilities. They use the balance sheet to evaluate whether a company is over-leveraged.
- Relative importance. While the relative importance of the two statements can depend on the individual, the income statement is generally considered more important than the balance sheet.
Income Statement vs Profit and Loss Statement
There is no difference between the income statement and the profit and loss statement. Indeed, the income statement is commonly referred to as the profit and loss (P&L) statement, since it outlines how much money a company earned and lost within a period of time.
Less often, the income statement is also called the statement of revenue and expense or the statement of operations. All of these terms describe the same type of financial report and can be used interchangeably.
Income Statement Example
Let us take a look at a single-step income statement from a fictional company for the year that ended on December 31, 2022:
Year Ended December 31, 2022
|Revenue and Gains||$4,268|
|Cost of Goods Sold||$2,800|
|Selling, General and Admin Expense||$930|
|Loss on Sale of Equipment||$5|
|Expenses and Losses||$3,747|
Revenue and Gains - Expenses and Losses
In this example, the total Revenue and Gains of Company ABC are calculated by adding the earnings received from sales and investment income. The Expenses and Losses value can be determined by aggregating the COGS, SG&A, interest expense, and loss on the sale of equipment. Finally, the Net Income is found by subtracting Expenses and Losses from Revenue and Gains.
How to Read and Interpret the Income Statement
The income statement is broken down into different line items, which can be either grouped together into categories or stand alone as their own categories. The statement should be read linearly, starting from the top line and all the way to the bottom line:
- In the above example, the income statement starts with the line items that add up to the total Revenue and Gains of the company over a specified period of time.
- Next are the line items that add up to the total Expenses and Losses of the company during the same period.
- Finally, the last line of the income statement is Net Income, calculated by subtracting Expenses and Losses from Revenue and Gains.
Note that when the values of Revenue and Gains, as well as Expenses and Losses, are used to arrive at the Net Income value, you are dealing with a single-step income statement.
Larger companies often use multi-step income statements, which separate operating revenues, gains, and expenses from non-operating revenues, gains, and expenses. The company’s profitability is then evaluated at four levels: gross, operating, pre-tax, and post-tax.
What Insights Should You Look for in an Income Statement?
Reviewing an organization’s income statement can provide the reader with important insights into the financial performance of the company. Business management or external stakeholders calculate numerous metrics to analyze the income statement data and conduct a more in-depth assessment of the company.
Many times, income statements are used for comparative company analysis. With this type of analysis, you would find income statement metrics for similar companies within the industry and compare them to one another. For example, you could calculate gross profit margin and total revenue growth to compare how competitor companies perform relative to each other.
Steps to Prepare an Income Statement
To prepare an income statement, business owners or accountants must analyze and report their revenues and expenses in order to calculate gross profit or losses for a reporting period. Below, we have outlined the ten steps you must follow to prepare an accurate income statement for your business.
Step One: Choose a Reporting Period
The reporting period is the specific period of time that the income statement covers. Monthly, quarterly, and annual income statements are common, but which reporting period is right for your company will depend on your goals.
For example, a monthly report describes a shorter period of time, which makes it easier to apply tactical changes that will affect the next month’s business activities. On the other hand, a quarterly or annual report provides a higher-level analysis, which can help to identify longer-term trends.
Step Two: Generate a Trial Balance Report
Before creating an income statement, you will need to generate a standard trial balance report. Trial balance reports are internal documents that outline the final balance of each account in the general ledger for a specific reporting period. Such reports can be easily generated through special accounting software.
Step Three: Calculate Total Revenue
Next, you would need to calculate the total revenue that your business has generated during the reporting period of your choice.
If you are preparing the income statement for a particular line of business, you should focus on the revenue from services or products that fall within this business segment. On the other hand, if you are preparing the income statement for your entire company, you must include revenue from all lines of business.
Step Four: Determine the Cost of Goods Sold (COGS)
Next, calculate the total COGS value for any service or product that has produced revenue for your business during the reporting period. This should include direct and indirect costs of producing and selling products or services, such as material expenses, direct labor expenses, costs of parts or components, distribution costs, and more.
Step Five: Calculate Gross Profit
Next, you would need to determine the gross profit generated during the reporting period. This value can be found by simply subtracting the COGS value from business revenue.
Step Six: Figure Operating Expenses
Operating expenses include all indirect costs associated with running a business. Such expenses are not directly related to the process of producing and distributing products or services; however, they are necessary to keep the business up and running. Some examples of operating expenses include rent, office supplies, utilities, overhead costs, and legal fees.
Step Seven: Calculate Income
Income, or Earnings Before Interest and Taxes (EBIT), can be calculated by subtracting operating expenses from gross profit. In a nutshell, this value describes the pre-tax income your company has generated over the reporting period.
Step Eight: Tally Interest and Taxes
Next, you need to evaluate interest and tax charges. To calculate interest charges, you need to know how much money the business owes to creditors, and what interest is being charged on that amount. You can use specialized accounting software to automatically tally the interest charges for the reporting period.
You also need to find the total tax spending during the reporting period. This includes federal, state, and local taxes, as well as any payroll taxes.
Step Nine: Calculate Net Income
Net income can be calculated as EBIT minus interest and taxes. The remaining value reflects the business funds available to be used for various purposes. For example, you could use your net income to distribute dividends to shareholders, add to a reserve, support research and development, or expand your business.
Step Ten: Finalize the Income Statement
Finally, add a header to the report that identifies it as an income statement, includes your business name, and details the reporting period covered by the statement.
Congratulations, your income statement is now complete! You can use it to evaluate the financial health of your company and share it with potential creditors and investors.
The income statement is an important financial report used to evaluate the financial performance of a company. It details business revenues and expenses over a specified period of time, providing valuable insights into the company’s internal activities and profitability. Preparing and interpreting income statements is relatively simple, but can be made even easier with specialized accounting software.