What Is an Income Statement?
An income statement is one of the three important financial statements used for reporting a company’s financial performance over a specific accounting period. The other two key statements are the balance sheet and the cash flow statement.
Also known as the profit and loss (P&L) statement or the statement of revenue and expense, the income statement primarily focuses on the company’s revenue and expenses during a particular period. The best way to analyze a company and decide whether you should invest is to know how to dissect its income statement.
- An income statement is one of the three major financial statements (along with the balance sheet and the cash flow statement) that report a company’s financial performance over a specific accounting period.
- Net Income = (Total Revenue + Gains) - (Total Expenses + Losses)
- Total revenue is the sum of both operating and nonoperating revenue, while total expenses include those incurred by primary and secondary activities.
- Revenue is not receipts. Revenue is earned and reported on the income statement. Receipts (cash received or paid out) are not.
- An income statement provides valuable insights into a company’s operations, the efficiency of its management, underperforming sectors, and its performance relative to industry peers.
An Introduction To The Income Statement
Understanding the Income Statement
The income statement is an important part of the company performance reports that must be submitted to the U.S. Securities and Exchange Commission (SEC). While a balance sheet provides the snapshot of a company’s financials as of a particular date, the income statement reports income through a particular time period, usually a quarter or a year, and its heading indicates the duration, which may read as “For the (fiscal) year/quarter ended June 30, 2021.”
The income statement focuses on four key items: revenue, expenses, gains, and losses. It does not differentiate between cash and non-cash receipts (sales in cash vs. sales on credit) or cash vs. non-cash payments/disbursements (purchases in cash vs. purchases on credit). It starts with the details of sales and then works down to compute net income and eventually earnings per share (EPS). Essentially, it gives an account of how the net revenue realized by the company gets transformed into net earnings (profit or loss).
Revenue and Gains
The following are covered in the income statement, though its format may vary, depending upon the local regulatory requirements, the diversified scope of the business, and the associated operating activities:
Revenue realized through primary activities is often referred to as operating revenue. For a company manufacturing a product, or for a wholesaler, distributor, or retailer involved in the business of selling that product, the revenue from primary activities refers to revenue achieved from the sale of the product. Similarly, for a company (or its franchisees) in the business of offering services, revenue from primary activities refers to the revenue or fees earned in exchange for offering those services.
Revenue realized through secondary, noncore business activities is often referred to as nonoperating, recurring revenue. This revenue is sourced from the earnings that are outside the purchase and sale of goods and services and may include income from interest earned on business capital parked in the bank, rental income from business property, income from strategic partnerships like royalty payment receipts, or income from an advertisement display placed on business property.
Also called other income, gains indicate the net money made from other activities, like the sale of long-term assets. These include the net income realized from one-time nonbusiness activities, such as a company selling its old transportation van, unused land, or a subsidiary company.
Revenue should not be confused with receipts. Revenue is usually accounted for in the period when sales are made or services are delivered. Receipts are the cash received and are accounted for when the money is actually received. For instance, a customer may take goods/services from a company on Sept. 28, which will lead to the revenue being accounted for in the month of September. Owing to his good reputation, the customer may be given a 30-day payment window. It will give him until Oct. 28 to make the payment, which is when the receipts are accounted for.
Expenses and Losses
The cost for a business to continue operation and turn a profit is known as an expense. Some of these expenses may be written off on a tax return, if they meet Internal Revenue Service (IRS) guidelines.
These are all expenses incurred for earning the normal operating revenue linked to the primary activity of the business. They include cost of goods sold (COGS); selling, general and administrative (SG&A) expenses; depreciation or amortization; and research and development (R&D) expenses. Typical items that make up the list are employee wages, sales commissions, and expenses for utilities such as electricity and transportation.
These are all expenses linked to noncore business activities, like interest paid on loan money.
Losses as Expenses
These are all expenses that go toward a loss-making sale of long-term assets, one-time or any other unusual costs, or expenses toward lawsuits.
While primary revenue and expenses offer insights into how well the company’s core business is performing, the secondary revenue and expenses account for the company’s involvement and its expertise in managing the ad hoc, noncore activities. Compared with the income from the sale of manufactured goods, a substantially high-interest income from money lying in the bank indicates that the business may not be using the available cash to its full potential by expanding the production capacity, or that it is facing challenges in increasing its market share amid competition. For example, recurring rental income gained by hosting billboards at the company factory situated along a highway indicates that management is capitalizing upon the available resources and assets for additional profitability.
Income Statement Structure
Mathematically, net income is calculated based on the following:
Net Income = (Revenue + Gains) - (Expenses + Losses)
To understand the above formula with some real numbers, let’s assume that a fictitious sports merchandise business, which additionally provides training, is reporting its income statement for a recent hypothetical quarter.
It received $25,800 from the sale of sports goods and $5,000 from training services. It spent various amounts as listed for the given activities that total $10,650. It realized net gains of $2,000 from the sale of an old van, and it incurred losses worth $800 for settling a dispute raised by a consumer. The net income comes to $21,350 for the given quarter. The above example is the simplest form of the income statement that any standard business can generate. It is called the single-step income statement as is based on the simple calculation that sums up revenue and gains and subtracts expenses and losses.
However, real-world companies often operate on a global scale, have diversified business segments offering a mix of products and services, and frequently get involved in mergers, acquisitions, and strategic partnerships. Such a wide array of operations, diversified set of expenses, various business activities, and the need for reporting in a standard format as per regulatory compliance leads to multiple and complex accounting entries in the income statement.
Listed companies follow the multiple-step income statement, which segregates the operating revenue, operating expenses, and gains from the nonoperating revenue, nonoperating expenses, and losses, and offers many more details through the income statement produced this way.
Essentially, the different measures of profitability in a multiple-step income statement are reported at four different levels in a business’ operations: gross, operating, pretax, and after-tax. As we’ll see shortly in the following example, this segregation helps in identifying how the income and profitability are moving/changing from one level to the other. For instance, high gross profit but lower operating income indicates higher expenses, while higher pretax profit and lower post-tax profit indicates loss of earnings to taxes and other one-time, unusual expenses.
Let’s look at an example based on the 2021 annual income statements of two large, publicly listed, multinational companies from different sectors: technology (Microsoft) and retail (Walmart).
Reading Standard Income Statements
The focus in this standard format is to calculate the profit/income at each subhead of revenue and operating expenses and then account for mandatory taxes, interest, and other nonrecurring, one-time events to arrive at the net income that is applicable to common stock. Though calculations involve simple additions and subtractions, the order in which the various entries appear in the statement and their relationships often get repetitive and complicated. Let’s take a deep dive into these numbers for better understanding.
The first section, titled Revenue, indicates that Microsoft’s gross (annual) profit, or gross margin, for the fiscal year ending June 30, 2021, was $115.86 billion. It was arrived at by deducting the cost of revenue ($52.23 billion) from the total revenue ($168.09 billion) realized by the technology giant during this fiscal year. Just over 30% of Microsoft’s total sales went toward costs for revenue generation, while a similar figure for Walmart in its fiscal year 2021 was about 75% ($429 billion/$572.75 billion). It indicates that Walmart incurred much higher cost than Microsoft to generate equivalent sales.
The next section, called Operating Expenses, again takes into account Microsoft’s cost of revenue ($52.23 billion) and total revenue ($168.09 billion) for the fiscal year to arrive at the reported figures. As Microsoft spent $20.72 billion on R&D and $25.23 billion on SG&A expenses, total operating expenses are computed by summing all these figures ($52.23 billion + $20.72 billion + $25.23 billion = $98.18 billion).
Reducing total operating expenses from total revenue leads to operating income (or loss) of $69.92 billion ($168.09 billion - $98.18 billion). This figure represents the earnings before interest and taxes (EBIT) for its core business activities and is again used later to derive the net income.
A comparison of the line items indicates that Walmart did not spend anything on R&D and had higher SG&A and total operating expenses than Microsoft.
Income from Continuing Operations
The next section, titled Income from Continuing Operations, adds net other income or expenses (like one-time earnings), interest-linked expenses, and applicable taxes to arrive at the net income from continuing operations ($61.27 billion) for Microsoft, which is nearly 60% higher than that of Walmart ($13.67 billion).
After discounting for any nonrecurring events, it’s possible to arrive at the value of net income applicable to common shares. Microsoft had a much higher net income of $61.27 billion compared with Walmart’s $13.67 billion.
Earnings per share are computed by dividing the net income figure by the number of weighted average shares outstanding. With 7.55 billion outstanding shares for Microsoft, its 2021 EPS came to $8.12 per share ($61.27 billion ÷ 7.55 billion). With Walmart having 2.79 billion outstanding shares that fiscal year, its EPS came to $4.90 per share ($13.67 billion ÷ 2.79 billion).
Microsoft had a lower cost for generating equivalent revenue, higher net income from continuing operations, and higher net income applicable to common shares compared with Walmart.
Uses of Income Statements
Though the main purpose of an income statement is to convey details of profitability and business activities of the company to the stakeholders, it also provides detailed insights into the company’s internal activities for comparison across different businesses and sectors. By understanding the income and expense components of the statement, an investor can appreciate what makes a company profitable.
Based on income statements, management can make decisions like expanding to new geographies, pushing sales, expanding production capacity, increased use of or the outright sale of assets, or shutting down a department or product line. Competitors also may use them to gain insights about the success parameters of a company and focus areas such as lifting R&D spending.
Creditors may find income statements of limited use, as they are more concerned about a company’s future cash flows than its past profitability. Research analysts use the income statement to compare year-on-year and quarter-on-quarter performance. One can infer, for example, whether a company’s efforts at reducing the cost of sales helped it improve profits over time, or whether management kept tabs on operating expenses without compromising on profitability.
The Bottom Line
An income statement provides valuable insights into various aspects of a business. It includes readings on a company’s operations, the efficiency of its management, the possible leaky areas that may be eroding profits, and whether the company is performing in line with industry peers.