An income statement is one of the three important financial statements that companies use to report their financial performance. The reporting occurs over a specific accounting period, and the other two key statements are the balance sheet and the statement of cash flows.
Income statements are also known as profit and loss statements, or statements of revenue and expense. They mainly focus on the company’s revenues and expenses during a particular period. Income statements offer valuable insight into a company’s operations, show how efficient the management is, and identify underperforming sectors and their performance related to industry peers.
What is an Income Statement?
An income statement is a financial statement that helps you understand the financial health of your business. It shows you the company’s income and expenditures, along with whether a company is making a profit or loss for a given period. It can consist of numbers from last month, from the last few months, over a certain quarter, or over the course of a year. Income statements are beneficial in assisting team leaders with making crucial business decisions.
What is the Importance of an Income Statement?
An income statement helps business owners determine if they can generate profit by increasing revenues, decreasing costs, or both. Additionally, it highlights the effectiveness of the strategies that the business set at the beginning of a financial period. To gauge if strategies have paid off, business owners can refer to this document. Based on their analysis, they can then develop the best solutions to yield more profit. Other benefits of income statements are frequent reporting, pinpointing future expenses or unexpected expenditures, and providing an overall analysis of a company.
What are the Different Parts of an Income Statement?
Income statements are divided into four elements, and each element may be broken down further to include individual line items. The following are the various important parts of an income statement.
| Part | Definition |
Revenue |
What is revenue? Revenue (operating revenue or income) includes the income or profits that you earn through offerings of services and product sales. You earn these profits before paying any interest or taxes on them. Items such as products sold, services offered, interest earned, and rental income are part of revenue. |
Expenses/cost of goods sold |
What is an expense? Some expenses are required so that businesses can operate. These expenses are also called the cost of goods sold. It is the cost of materials or labor that is required to offer products or services to the customer. Some examples are rent, utilities, labor, administrative costs, and interest paid on a loan. |
Gross profit |
Gross profit is the combination of all types of profit of an organization minus the costs associated. You can determine the gross profit by adding up all types of profit and then subtracting the cost of goods sold. However, gross profit is not the same thing as net profit. Net profit considers other expenses like interest and taxes, while gross profit only accounts for the cost of goods sold. |
Losses |
Losses can include individual costs like depreciation and amortization. They are used to divide the loss of value and depreciation among assets over multiple categories. You determine your losses by adding up the value of all sales and then subtracting the cost of goods to reach the gross profit. From this point, you will subtract any losses. |
EBITDA |
EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” EBITDA is not a part of every income statement but may be used when comparing profitability among several businesses. When calculating the EBITDA, you must combine net income with taxes, interest expenses, depreciation, and amortization. |
Why is the Income Statement Created First?
Income statements are prepared first since they provide necessary information that will help generate other financial statements. As mentioned, income statements break down all your company’s revenues and expenses. Revenues are any sales your business produces. Expenses can be various operating costs such as inventory, rent, or utilities. Income statements allow you to see your business’s net income and study your sales vs. debt.
When is the Income Statement Prepared?
Income statements are prepared first. They break down all of a company’s revenues and expenses. The income statement should be prepared first since it offers critical information needed to generate other financial statements. By creating the income statement first, you can find out later if you have a net income or loss for the period. This is after listing out any expenses your company had during the period and subtracting the expenses from your revenue.
How do you Make an Income Statement?
Income statements list all relevant information in a way that is easy to comprehend. Follow these steps to create a proper income statement:
- List the company’s revenue or operating income.
The company’s revenue is the gross of all costs related to creating products or offering services. All types of company revenue must be mentioned.
- Input the cost of goods sold.
Calculate the cost of goods sold by adding the value of your inventory to the amount of income from purchases or services sold. The formula is Beginning Inventory + purchases sold = ending inventory.
- Calculate gross profit.
Gross profit is determined by subtracting the cost of goods sold from the overall sales revenue. Also, include any temporary gains such as the sale of company assets or a one-time sale of unused property.
- Incorporate details about expenses.
Combine all eligible expenses including interest, and enter the total amount.
- Include net income before taxes.
You can calculate net income before taxes by taking the gross profit and subtracting the total cost of expenses from it.
- List depreciation and amortization expenses.
These are costs often determined by an accountant. Input these numbers into the income statement, and then compute your net income.
Who Makes Use of an Income Statement?
Two main groups of people use income statements: internal and external users. Internal users consist of company management and the board of directors, who use this information to analyze the business’s standing and make decisions to turn a profit. Also, they can act on any issues regarding cash flow.
On the opposite end, external users are investors, creditors, and competitors. Investors check whether the company is positioned to grow and be profitable in the future. This will guide them in deciding if they should invest in the business. Creditors use the income statement to gauge whether the company has enough cash flow to pay off its loans or take out a new loan. Competitors use them to get details about the success parameters of a business and know about areas where the business is spending an extra bit.
How to Interpret an Income Statement?
Income statements tell you how much you have spent in a certain period and how much your business has made. Learning the meaning of all the line items and what they indicate for your company’s performance will help you with day-to-day operations.
Various line items are broken down on income statements. Some can be grouped into categories, while others stand alone. As for interpretation, the income statement follows a linear path. It flows from the top line to the bottom line. The top line can be considered a “rough draft” of the money you have made. It includes your total revenue before accounting for any expenses. Your bottom line is a “final draft,” which is the profit you earned after taking account of all expenses. When you acknowledge all of these items and closely analyze them, you can interpret an income statement adequately.
What Can Investors Learn from an Income Statement?
Investors can learn several important things from income statements. These documents can inform investors about the focus areas of improvement for a company, show them how future cash flows, and allow them to check on various operations throughout the year. Any time investors decide to take stock in a company, they are taking a risk on its profitability and success rate. So, it is crucial to be aware of certain factors before making a final decision.
Why are Income Statements so Important to Investors?
Income statements detail how a business will use revenue and turn it into profits or losses later. When income statements are divided into different categories, investors along with business leaders can gauge the value and efficiency of a company. These documents provide a reasonable level of accuracy that makes investors feel more at ease when taking stock in a company.
What is the Function of the Income Statement in Competitors?
Income statements provide information on a company’s operations and overall success. Competitors view these statements to gain knowledge about the success parameters of a company and its focus areas, such as increasing R&D (research and development) spending. Competitors aim to compare the findings with their business models to develop new strategies for business.
How is Tax Calculated on an Income Statement?
One of the main lines to notice on an income statement is income before taxes. After deducting interest payments, and relying on the business and other expenses, the result is the profit a company made before paying its income tax bill.
The effective tax rate is the overall tax rate the company pays on its earned income. To calculate the effective tax rate on an income statement:
- Divide the income tax expense by the earnings (or income earned) before taxes
- Tax expenses are generally the last item before net income (the bottom line) on an income statement
- For instance, if a company earned $100,000 before taxes and paid $25,000 in taxes, then the effective rate calculation is 25,000 / 100,000, or 0.25. Now, it is clear that the company paid an overall rate of 25% in taxes on income.
Is the Income Statement Useful in Determining a Company’s Profitability?
An income statement is helpful in determining a company’s profitability. Income statements report your business’s profits and losses over a certain period. They can also assist in summarizing business operations for a specific time frame (ex. monthly or quarterly). Income statements provide insight into a company’s income and expenses. The more you know about the risks and benefits involved in a company, the better decisions you can make.
