An income statement is one of the three main financial statements that show the performance of a business over a period of time. The other two are the balance sheet and the cash flow statement. The income statement summarizes the revenues, expenses, and profits or losses of a business from its operations and other activities.
The income statement is also known as the statement of operations, the statement of earnings, or the profit and loss statement. The income statement is important because it shows how profitable a business is and how well it manages its costs and revenues. It also provides useful information for investors, creditors, managers, and other stakeholders to evaluate the financial health and performance of a business.
The income statement is usually prepared on a monthly, quarterly, or annual basis. The income statement follows a general format that starts with sales revenue and ends with net income. However, the income statement may vary depending on the nature and complexity of the business and the accounting standards used.
The basic format of the income statement is:
Sales Revenue- Cost of Goods Sold= Gross Profit- Operating Expenses= Operating Income+/- Non-operating Income and Expenses= Earnings Before Interest and Taxes (EBIT)- Interest Expense= Earnings Before Taxes (EBT)- Income Tax Expense= Net Income
Let’s look at each component of the income statement in more detail.
Sales Revenue
Sales revenue is the amount of money that a business earns from selling its goods or services to its customers. Sales revenue is also called sales, net sales, or top line. Sales revenue is calculated by multiplying the quantity of goods or services sold by the selling price per unit. Sales revenue may be reduced by discounts, returns, and allowances given to customers.
Cost of Goods Sold
Cost of goods sold (COGS) is the direct cost of producing or purchasing the goods or services that a business sells to its customers. COGS includes the cost of materials, labor, and overhead that are directly related to the production or acquisition of the goods or services. COGS does not include indirect costs such as selling, general, and administrative expenses. COGS is also called cost of sales or cost of revenue.
Gross Profit
Gross profit is the difference between sales revenue and cost of goods sold. Gross profit shows how much a business earns from its core operations before deducting any other expenses. Gross profit is also called gross margin or gross income. Gross profit can be expressed as a dollar amount or as a percentage of sales revenue. The gross profit margin is calculated by dividing gross profit by sales revenue and multiplying by 100%.
Operating Expenses
Operating expenses are the costs that a business incurs to run its day-to-day operations and support its core activities. Operating expenses include selling, general, and administrative expenses, such as salaries, rent, utilities, advertising, depreciation, and amortization. Operating expenses are also called operating costs or operating expenditures.
Operating Income
Operating income is the difference between gross profit and operating expenses. Operating income shows how much a business earns from its core operations after deducting all the related costs. Operating income is also called operating profit, operating earnings, or earnings before interest and taxes (EBIT). Operating income can be expressed as a dollar amount or as a percentage of sales revenue. The operating income margin is calculated by dividing operating income by sales revenue and multiplying by 100%.
Non-operating Income and Expenses
Non-operating income and expenses are the gains and losses that a business incurs from activities that are not related to its core operations. Non-operating income and expenses include interest income, interest expense, dividend income, gains or losses from investments, foreign exchange gains or losses, and extraordinary items. Non-operating income and expenses are also called other income and expenses or below-the-line items.
Earnings Before Taxes
Earnings before taxes (EBT) is the difference between operating income and non-operating income and expenses. EBT shows how much a business earns before paying income taxes. EBT is also called pre-tax income, pre-tax profit, or taxable income.
Income Tax Expense
Income tax expense is the amount of money that a business pays to the government as income taxes. Income tax expense is calculated by multiplying the earnings before taxes by the effective tax rate. The effective tax rate is the average rate of income tax that a business pays on its taxable income. The effective tax rate may differ from the statutory tax rate due to tax credits, deductions, exemptions, and other adjustments.
Net Income
Net income is the difference between earnings before taxes and income tax expense. Net income shows how much a business earns after paying all its expenses and taxes. Net income is also called net profit, net earnings, or bottom line. Net income can be expressed as a dollar amount or as a percentage of sales revenue. The net income margin is calculated by dividing net income by sales revenue and multiplying by 100%.
Net income is the most important figure on the income statement, as it represents the ultimate measure of a business’s profitability and performance. Net income is also the source of retained earnings, which are the earnings that a business reinvests in itself or distributes to its owners as dividends.
How to Read an Income Statement
To read an income statement, you need to understand the meaning and purpose of each line item and how they relate to each other. Here are some tips and questions to help you read an income statement:
- Compare the income statement with the previous periods and the industry averages to see the trends and benchmarks of the business’s performance.
- Analyze the sales revenue and the growth rate to see how well the business is generating income from its core activities.
- Analyze the cost of goods sold and the gross profit margin to see how efficiently the business is producing or acquiring its goods or services and how much it earns from each dollar of sales.
- Analyze the operating expenses and the operating income margin to see how effectively the business is managing its costs and how much it earns from its core operations.
- Analyze the non-operating income and expenses to see how much the business is affected by its financing and investing activities and other factors outside its control.
- Analyze the income tax expense and the effective tax rate to see how much the business pays to the government and how it affects its profitability.
- Analyze the net income and the net income margin to see how profitable the business is and how much it retains or distributes to its owners.
By reading an income statement, you can gain valuable insights into the financial performance and profitability of a business. You can also use the income statement to calculate various financial ratios and metrics that can help you evaluate the business’s strengths and weaknesses. The income statement is a powerful tool for financial analysis and decision making.
