What is an Income Statement?
The income statement (or statement of earnings, or profit and loss statement) is one of the three primary financial statements. Alongside the balance sheet and the statement of cash flow, it can be instrumental in understanding the financial performance and health of a company.
It is used for reporting companies’ profits or losses over a defined period. The statement breaks down revenue and expenses into subcategories. This is useful as it gives powerful insight into companies activities.
4 Key Concepts
The key purpose of the income statement is to answer the question: “Did the entity operate at a profit?”
To give an adequate and structured answer, the income statement focuses on four essential items:
- Revenue
- Expenses
- Gains
- Losses
Typically, we first report revenues and subtract all the expenses incurred.
Then, by adding gains and deducting losses, we work down to compute Net Income and Earning Per Share (EPS). If the two last values are positive, then the firm is profiting.
But… what are revenue, expenses, gains, and losses?
Revenue
Often called net sales, revenue is the total value generated from operating activities. When a company sells a product or a service to a customer and received cash or creates an account receivable, the company generates revenue.
Expenses
The total cost of operations that the company faces to generate are called revenue. This can include COGS (Cost of Good Sold), SG&A (Selling, General, and Administrative, and others (such as interest expense).
Gain
An increase in the net value of an asset or property is referred to as a gain. It arises when the selling price of an asset is higher than the original purchase price. Therefore, it is the value generated from non-operating activities.
Loss
The decrease in the net value of an asset or property is a loss. In essence, it is an expense incurred from non-operating activities.
Components of the Income Statement
Every income statement, most likely than not, will have its own little variation. Every industry, sector, and company is different, and this translates into the financial statements.
Nonetheless, several general items appear frequently in most income statements. The most common items are:
- Revenue, as defined above, is the total value generated from operating activities.
- Cost of goods sold, often abbreviated to COGS, represents the total cost of merchandise removed from inventory and delivered to customers as a result of sales. It includes all the direct costs associated with revenue.
- Gross profit is the difference between net sales and COGS.
- Selling, General, and Administrative, known more commonly as SG&A, represents the operating expense of a firm. It includes most of the indirect cost associated with running the business, such as wages, rent, and office expenses.
- EBITDA, which stands for Earnings before Interest, Tax, Depreciation, and Amortization, is calculated by deducting SG&A from gross profit.
- Depreciation and Amortization Expenses are non-current accounting expenses. Essentially, given the high cost of capital assets like PP&E (Property, Plant, and Equipment), accountants spread out the cost of long-lasting and expensive assets to give a more accurate sense of a company’s performance.
- EBIT, most commonly known as operating Income, stands for Earnings before Interest and Taxes. It is the profit recorded by the frim before any gains and losses are taken into account. It is also commonly used by investors to assess the value of companies through multiples analysis.
- Interest Expenses represents the cost of using borrowed funds. It is considered a non-operating expense as it shows how assets are financed, not how they are used.
- Other Expenses can include all the industry-specific costs of business, such as R&D (research and development) and technology. They can be either operating or non-operating expenses.
- EBT is equal to EBIT minus interest expenses. It means Earnings before Taxes but is commonly referred to as pre-tax Income.
- Income Tax, also known as income tax expense or provision for income taxes, is the total amount of taxes charged on a firm’s EBT.
- Net Income is the total profit or loss that a firm generates over a defined period.
- Earnings per share of common stock outstanding (EPS) is a metric present in mainly public companies income statements, and it is equal to Net Income divided by Share Outstanding.
In a Nutshell
Test Yourself!
Public companies usually publish their financial statements on a quarterly and annual basis.
You can find US-based public company’s balance sheets on the US Securities and Exchange Commission (SEC). Search for the 10-K, and you will be ready to go to apply what you’ve just learned!
