Income Statement Basics You Need To Know
The Income Statement is one of the core financial statements used by business owners and their accountants to reflect the financial health of the business during a specific accounting period. Other crucial financial statements include The Balance Sheet, The Statement of Cash Flows, and The Statement of Shareholders’ Equity. The Income Statement has several names by which it is alternately known, including Statement of Operations, and Profit and Loss Statement.
Interested in learning more about all important financial statements? Check out our brief read What Are the Five Types of Financial Statements And How to Understand Them, or ZarMoney's detailed guide with examples The Types Of Financial Statements And Why Each Is Important here.
Other names under which you can find your Income Statement include:
- Statement of Income
- Statement of Earnings
- Statement of Operations
- Statement of Operating Results
- Profit and Loss Statement
What Does The Income Statement Show?
There is some confusion about what The Income Statement shows, as the name seems to imply that it would only show the money coming into a business. In truth, the idea is to show the profitability of the company during a specified period of time. Since profitability is a function of both the money coming in and the money going out, The Income Statement tracks both revenues and expenses.
Ultimately, The Income Statement should provide information about a company’s gains/profits or its losses. Depending on the reporting period that a company uses, The Income Statement can be a monthly statement, quarterly implemented, or an annual statement.
In other words, it summarizes the company's revenues (sales) and expenses for a fiscal quarter or a fiscal year.
The Income Statement has two basic formats. A single-step and a multi-step.
In the multi-step Income Statement, 4 measures of profitability are displayed at 4 essential points in a business's operations—gross, operating, pretax, and after-tax. In the single-step variation, the gross and operating income figures are not present.
In the single-step method, sales minus materials and production equal gross income. By deducting marketing costs, administrative costs, and R&D expenses from gross income, you get the operating income.
Investors must remind themselves that The Income Statement looks at revenues when they are realized, (when goods are shipped, services rendered, and expenses incurred), not when the actual cash flows in. The Income Statement corresponds in numbers with The Accrual Method of Accounting, rather than The Cash Method. With accrual accounting, the flow of accounting events through the income statement does not necessarily coincide with the actual receipt and disbursement of cash. The Income Statement measures profitability, not cash flow.
Why Is The Income Statement Important?
Many parties could be interested in The Income Statement, as it provides a clear view of whether a company is profitable or not. For example, banks or creditors might be unwilling to work with a business that shows consistent operational losses on its Income Statement.
In addition to lenders and creditors, this type of statement is essential to managers, stockholders, investors, the government, labour unions, competitors, other businesses considering mergers or acquisitions, and more. All these entities have reasons to be interested in how much money a company is bringing in, how much money it has going out, and whether those numbers reconcile to put the company in the red or the black.
How Information on Income Statements Is Presented
Every Income Statement follows the same basic structure. Specifically, every income statement breaks down into two categories. The first category is Revenue and gains. The second is the Expenses and losses.
Line items in each section should outline revenues or losses due to both primary activities and secondary activities. A primary activity might be producing and selling a product (for a manufacturer) or selling existing merchandise inventory (for a retailer). A secondary activity would be a profit or loss related to a peripheral activity, or not related to the core activities of producing, buying, or selling.
An example of a secondary activity would be a gain or loss related to a lawsuit settlement. Each activity should be recorded as a profit or loss and should represent the amount of money a company gained or lost through a specific activity.
Both sections of The Income Statement should include specific line items that outline individual transactions. For instance, if a company rents out a piece of equipment it isn’t using, the income from that rental would be recorded as a gain from a secondary activity.
However, the statement should also ultimately add up those line items into financial insights spanning the entire reporting period. Cost of sales/cost of goods sold, total operating expenses, revenue expenses, administrative expenses, net income or net profit, operating profit, and gross profit should all be totalled at the bottom of the statement.
Multi-Step Format Income Statement Accounts
- Net Sales (sales, revenue): Value of a business's sales of goods and services. In the long term perspective, profit margins on a business's existing products tend to eventually reach a maximum that is too hard to improve, so companies typically can grow no faster than their revenues.
- Cost of Sales (cost of goods/products sold (COGS), and cost of services):
- For a manufacturer, the cost of sales is the expense incurred for labour, raw materials, and manufacturing overhead used in the production of goods.
- For wholesalers and retailers, the cost of sales is essentially the purchase cost of merchandise used for resale.
- For service-related businesses, cost of sales represents the cost of services rendered or cost of revenues.
- Gross Profit (gross income or gross margin): A business's gross profit represent the difference between net sales and the cost of sales. But that's not all. It also provides the resources to cover all of the company's other expenses.
- Selling, General, and Administrative Expenses: SG&A. Company's operational expenses. It is often assumed that management has great control over this expense category. The trend of SG&A expenses, as a percentage of sales, is often checked for signs, both positive and negative, of managerial efficiency.
- Operating Income: Company's earnings from its normal operations before any non-operating income and/or costs such as interest expense, taxes, and special items.
- Interest Expense: Costs of company's borrowings.
- Pretax Income: An indicator of profitability, earnings before the income tax. It is an important section of The Income Statement.
- Income Taxes: An estimate or an account that has been created to cover the amount a company expects to pay in taxes.
- Special Items or Extraordinary Expenses: Restructuring charges, unusual or nonrecurring items, and discontinued operations. These write-offs are normally one-time events and as such, they need to be taken into consideration by investors.
- Net Income (net profit or net earnings): This is the bottom line, which is the most important element in a company's profitability. After the payment of dividends, net income becomes part of a company's equity position as retained earnings.
- Comprehensive Income: The items as foreign currency translations adjustments, minimum pension liability adjustments, and unrealized gains/losses on certain investments in debt and equity are items displayed in this category.
Income Statements are vital documents, both internally and externally. They provide crucial information about a company’s operations, its total profits or total expenses, and its ability to make money. In turn, they can inform operational or management decisions, help investors make smart decisions, assist creditors or lenders with risk assessment, and more.
The Income statement has many names, from which most commonly used are Statement of Income, Statement of Earnings, Statement of Operations, Statement of Operating Results, Profit and Loss Statement.
It is one of 5 most important financial statements, which are: Shareholder's Equity, Cash Flows Statement, The Balance Sheet and Foot Notes (which isn't really a statement, yet it is super important when managing your company's finances).
The Income Statement has 2 main forms: Single-step and multi-step. The multi-step form has the following accounts one needs to fill in every fiscal time required by internal and external stakeholders, including IRS, investors, employees and board of directors.
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