Understanding Your Income Statement
An income statement is typically prepared at the end of a business period (such as a Fiscal Year or Quarter) to assess profit or loss. It can be thought of like a motion picture. It reports how a company performed during the period presented, and shows whether that company’s operations have resulted in a profit or loss. Therefore, it shows how much money a company made and spent over the period. The period is shown in the header of the income statement.
To state this another way, it is a financial statement that shows how much revenue a company earned over a specific period (usually a year). An income statement also outlines the costs and expenses associated with earning that revenue. Typically, the final figure of this statement shows the company’s net earnings or losses. This tells you how much the company earned or lost over the period.
Drawing an Income Statement
To better understand how income statements are set up, it may be helpful to think of them as a set of stairs.
We start at the top with the total amount of sales made during the accounting period. Then we will go down, one step at a time. At each step, we make a deduction for costs or expenses associated with corresponding revenue. This means that each step will bring a revenue and an expense pair, or an expense item into the picture. At the last step, after deducting all expenses, we will learn how much the company earned or lost during the period. People often call this “the bottom line.” It is the company’s net earnings or loss.
Let’s take a closer look at each step of pulling together your Income Statement:
At the top of the income statement is the total amount of money brought in from sales of products or services.
This is the gross revenue or sales and often referred to as the “top line”. It’s “gross” because we have not deducted expenses from it, therefore a “gross” or unrefined number. Similar to your pay stub from your paycheck, which starts out listing your gross pay, then lists all your deductions and taxes down to your net pay. Likewise we start with gross revenue or sales and in each subsequent step, we will further refine it, approaching the net figure at the last step.
The next line lists money the company does not expect to collect on certain sales.
This could be, for instance, sales discounts or merchandise returns or bad checks. Therefore, it is a deductible item because it is non-collectable. Since it is a loss of revenue, we subtract it from sales to arrive at the company’s net revenue or “net sales.”
This step typically shows the costs associated with the sales also known as the “Cost of Goods Sold.”
This is the amount of money spent to produce the goods or services sold during the period. By deducting the Cost of Goods Sold, we get “gross profit” or “gross margin.” It is “gross” because there are still additional expenses that need to be deducted to arrive at our last step.
The next step deals with Operating Expenses. It is a comparatively bigger step on the stairs, simply because there can be a great number of them. Operating expenses are the expenses that go toward supporting a company’s operations for a given period. Operating expenses are different from the cost of sales because operating expenses cannot be linked directly to the production of the products or services rendered.
In our example, the operating expenses are divided into Selling Expenses and General Expenses. Selling expenses include those expenses spent to make a sale and can include marketing costs, travel, and commissions. General expenses can include salaries, research and development and depreciation or amortization.
Note: Depreciation or Amortization takes into account the wear-&-tear on assets such as machinery, tools and furniture, which are used over a long term or over a number of periods. Therefore, we also spread the cost of these assets over the periods they are used. The depreciation deducted from gross profit in a period is determined as a fraction of the original cost of the assets. This fractional amount is usually placed in a savings or depreciation account so that it is there to be used as a replacement cost at the end of the life of the equipment.
After all operating expenses are deducted from gross profit, we arrive at the figure of operating profit before interest and income tax expenses, also known as “income from operations.” In our example, Income from Operation equals Gross Profit minus Total Operating Expenses.
Next, we still need to account for interest income and interest expenses. Interest income is the money companies make from keeping their cash in interest-bearing savings accounts or other investments. Interest expense is the money companies paid in interest for money they borrow. We add or subtract the interest income and expense to arrive at the figure of the “Income Before Taxes.”
In the final step, income tax is deducted and we arrive at the bottom line or the last step of the stair: net profit or net losses.
Here we finally know about the profit or loss of a company. Specifically, whether or not the company made or lost money and, as in our example, whether they did better or worse than the previous year.
Note: Earnings per share on an income Statement
Some Income Statements also report earnings per share (or “EPS”). This figure is the earnings per share of investment made in the company. The calculation of EPS tells you how much money shareholders would receive if the company decided to distribute all of the net earnings for the period.
Fundamentals of Financial Statements, 4 Part Series