Mastering the Income Statement: A Beginner’s Guide to Financial Analysis

In Financial Analysis, one of the most essential Financial statements is the Income Statement, which details a company’s profits and expenses for a given time period. Anyone reading this document, from key executives and stakeholders to investors and employees, will receive a wealth of information.

Here’s a breakdown of all you need to know about Income Statements, including what they are, why they’re significant, and how to examine them, to help you gain this insight and make the most of these records.

What is Income Statement?

An organization’s revenue, costs, profits, and losses for a specific time period are the main topics of the Income Statement. An Income Statement, also known as a profit and loss (P&L) statement or a statement of sales and expenses, offers important information about a company’s operations, the effectiveness of its management, underperforming industries, and its performance in comparison to peers in the same industry.

It is also one of the three crucial financial statements used to describe a company’s financial performance throughout a certain accounting period. The balance sheet and the cash flow statement are the other two important statements.

The Income Statement is broken up into time periods that make sense given how the business operates. For internal reporting, the most typical periodic division is monthly, while other businesses might utilize a thirteen-period cycle. Total values are created from these periodic statements in order to calculate quarterly and annual results.

As it requires the least amount of data from the balance sheet and cash flow statement, this statement is a great place to start a financial model. The Income Statement thus precedes the other two main statements in terms of information.

These details are frequently included on an income statement:

Revenue: The amount of money received by a company during a reporting period.
Expenses: The amount of money spent by a company during a reporting period.
Costs of goods sold (COGS): The total expenses for the parts that make up any good or service that a business produces and sells.
Gross profit = revenue minus the cost of goods sold
Operating income: the difference between gross profit and operating expenses.
Before-tax income: less non-operating expenses than operating income
Net income: Earnings before taxation
Earnings per share (EPS): calculated by dividing net income by the number of outstanding shares.
Depreciation: The gradual loss of value in assets over time, including stock, machinery, and property
EBITDA stands for earnings before interest, taxes, depreciation, and amortization.

Importance of an Income Statement

An Income Statement assists business owners in determining if they can make a profit by raising sales, cutting expenses, or doing both. Additionally, it demonstrates the success of the plans the company made at the start of a given fiscal year. This document can be used by business owners to determine whether their strategies were successful. They can identify the finest methods to increase earnings based on their study.

Here are a few additional things that an income statement reveals.

Frequent reports: The Income Statement is produced either weekly or monthly, whilst other financial statements are issued annually. As a result, investors and business owners may keep a close eye on the company’s performance and make wise choices. This enables them to identify and address small business issues before they grow and become costly.
Identifying expenses: This statement identifies any upcoming costs, any unforeseen costs incurred by the business, and any areas that are above or under budget. Rent for the facility, employees, and other administrative charges are expenses. A small business may see that its expenses are rising as it starts to expand. These costs might include recruiting staff, purchasing supplies, and advertising the company.
Overview of the company: Income Statement provides investors with a general examination of the company they wish to invest in. This document can be examined by banks and other financial organizations to determine whether the company is creditworthy.

What’s the purpose of an Income Statement?

An Income Statement’s objective is to display a company’s financial success over a specific time frame. It provides financial Income Statement Accounts for a company’s operational activity.

You may discover all of the revenue and expense accounts for a specific time period in an income statement. Trial balances from any two points in time are used by accountants to construct income statements.

You can ascertain whether a company is making a profit from an income statement and other financial records like the cash flow statement, balance sheet, and annual report. You can also learn when costs are highest and lowest, how much is being paid to produce a product, and whether the company has the funds available to reinvest in the company.

Reviewing Income Statements on a regular basis helps accountants, investors, and business owners gauge how well a company is doing in comparison to its anticipated future performance and make appropriate adjustments to their course of action. For instance, a business owner whose company falls short of goals may change course to make up the ground the next quarter. Similarly to this, an investor may choose to sell one investment and invest in a business that is succeeding or exceeding expectations.

Components of an Income Statement

Since expenses and income depend on the type of operations or business conducted, the Income Statement may differ slightly between different companies. There are a few basic line items, nevertheless, that can be found on any Income Statement.

The most typical components of an Income Statement, include four main components revenue, expenses, profits, and losses. It makes no distinction between cash and non-cash receipts (sales made in cash vs sales made on credit) or cash and non-cash payments or disbursements (purchases made in cash against purchases made on credit). The computation of net income and ultimately earnings per share (EPS) begins with the breakdown of sales data. Essentially, it explains how the company’s net revenue is converted into net earnings (profit or loss).

Revenue

This is the first section of the Income Statement and provides a summary of the company’s gross revenues. There are two categories of revenue: operational and non-operating.

Operating Revenue

Operating revenue is a term frequently used to describe revenue generated by core activities. The term “revenue from primary activities” refers to income generated from the sale of a product for a company that manufactures that product as well as for a wholesaler, distributor, or retailer engaged in the business of selling that product. Similar to this, revenue from principal operations for a corporation (or its franchisees) engaged in the service industry refers to the income or fees received in exchange for providing those services.

Non-Operating Revenue

Non-Operating Revenue is a term frequently used to describe revenue generated by ancillary, noncore company activity. This income comes from sources other than the buying and selling of goods and services. Examples include interest income on business capital held in a bank, rental income from real estate owned by the business, income from joint ventures like royalty payment receipts, or income from an advertisement displayed on real estate owned by the business.

What Sets Operating Revenue Apart from Non-Operating Revenue?

Operating income is generated by a company’s main endeavor, such as the sale of its goods. Non-operating income originates from supplemental sources such as interest income from capital held in a bank or income from leasing commercial real estate.

Gains

Gains, sometimes referred to as other income, are the net proceeds from several kinds of transactions, like the selling of long-term assets. These comprise the net income from one-time nonbusiness ventures like the sale of a company’s old van for transportation, unused land, or a subsidiary business.

Receipts and revenue are two different concepts. Payment is typically recorded when goods are sold or services are rendered. Cash received is recorded as a receipt and is accounted for as soon as it is received.

For example, On September 28, a customer may purchase goods or services from a business, resulting in revenue that is recorded for September. Due to his good credit and reputation, the customer might be allowed a 30-day payment window, giving him till October 28 to pay—the date the receipts are totaled—to do so.

Expenses

Expenses are the costs incurred by a business to maintain operations and generate profits. If they adhere to Internal Revenue Service (IRS) regulations, certain of these expenses might be deducted from income on a tax return.

Primary-Activity Expenses

All of these costs were incurred in order to generate the typical operational revenue associated with the business’s main activity. These expenses consist of selling, general, and administrative (SG&A), depreciation or amortization, cost of goods sold (COGS), and research and development (R&D) costs. Employee salaries, sales commissions, and costs for services like energy and transportation typically appear on the list.

Secondary-Activity Expenses

These are all costs associated with non-core business operations, such as interest on loans.

Losses

These are all costs associated with a loss-making sale of long-term assets, one-time charges, unexpected costs, or expenditures associated with legal actions.

Secondary revenue and fees reflect the company’s involvement and proficiency in managing ad hoc, non-core operations whereas primary revenue and expenses provide information about how effectively the company’s core business is operating. A business may not be utilizing the available cash to its full potential by expanding the production capacity if the income from money in the bank is significantly higher than the income from the sale of manufactured goods, or it may be having trouble growing its market share in the face of competition.

For example, the fact that the company plant beside a highway receives recurring rental income from hosting billboards shows that management is making the most of the assets and resources on hand to increase profitability.

Income Statement Structure

The following formulas are used to determine net income mathematically:

Net Income = (Revenue + Gains) – (Expenses + Losses)

Let’s pretend that a hypothetical sports goods company that also offers training is presenting its income statement for a recent hypothetical quarter in order to illustrate the aforementioned method with some actual data.

Mastering the Income Statement: A Beginner's Guide to Financial Analysis — Source: Investopedia

From the sale of sporting goods and $5,000 from training services, it made $25,800. It spent a total of $10,650 on the mentioned expenses for the given activities. It made net gains of $2,000 from the sale of an old van, but it also suffered losses of $800 for resolving a customer complaint. $21,350 is the net income for the particular quarter. The most basic Income Statement that a typical business can produce is the one shown above – The single-step Income Statement. The single-step income statement is based on a straightforward calculation that adds revenue and gains and deducts expenses and losses, hence the name.

However, real-world businesses frequently engage in mergers, acquisitions, and strategic partnerships, have diversified business segments offering a variety of products and services, and frequently operate on a global scale. The income statement contains numerous and intricate accounting entries as a result of the vast variety of operations, varied sets of expenses, different business activities, and requirements for reporting in a standard manner for regulatory compliance.

Listed firms use an income statement that is prepared in numerous steps and separates operational revenue, operating expenses, and gains from non-operating revenue, non-operating expenses, and losses. This method produces an income statement that provides much more information.

In a multiple-step income statement, the various profitability metrics are essentially reported at four different operational levels: gross, operating, pretax, and after-tax. This segmentation aids in determining how income and profitability are shifting/changing from one level to another, as we’ll see shortly in the example that follows. For instance, a high gross profit but a low operational income suggests increased costs, whereas a high pre-tax profit but a low post-tax profit suggests that gains were lost to taxes and other one-time, exceptional expenses.

How to read an Income Statement

In this standard structure, the emphasis is on determining the profit/income at each subhead of revenue and operational expenses before taking into account required taxes, interest, and other nonrecurring, one-time occurrences to determine the net income that relates to common shares. The order in which the different elements occur in the statement and their relationships are frequently repeated and convoluted, even if calculations just require simple adds and subtraction. To have a deeper insight, let’s go into these figures.

Revenue Section

Microsoft’s gross (annual) profit, or gross margin, for the fiscal year ended June 30, 2021, was $115.86 billion, according to the first portion of the report titled Revenue. It was calculated by subtracting the cost of revenue ($52.23 billion) from the sum of the company’s revenues ($168.09 billion) for the current fiscal year. Microsoft spent just over 30% of its total sales on revenue-generating expenses, compared to Walmart’s approximate 75% ($429 billion/$572.75 billion) for the same period in 2021. It shows that Walmart spent far more money than Microsoft did to produce the same amount of sales.

Operating Expenses

The stated values for the Operating Expenses section are calculated by again using Microsoft’s cost of revenue ($52.23 billion) and total revenue ($168.09 billion) for the fiscal year. Total operational expenses are calculated by adding these numbers together ($52.23 billion + $20.72 billion + $25.23 billion = $98.18 billion), as Microsoft spent $20.72 billion on R&D and $25.23 billion on SG&A costs.

Operating income (or loss) is calculated as total operating expenses less total revenue, which results in a result of $69.92 billion ($168.09 billion – $98.18 billion). The net income is later calculated using this figure, which represents the company’s earnings before interest and taxes (EBIT) for its main business operations.

Comparing the line items reveals that Walmart spent less on SG&A and total operating costs than Microsoft while spending nothing on R&D.

Income Statement analysis

The two techniques of vertical analysis and horizontal analysis are frequently used to read and examine the financial records of a business. The way an Income Statement is read and the comparisons you can draw from each form of analysis vary between the two.

Vertical Analysis

Vertical analysis is a type of financial analysis where each line item in the statement is listed as a percentage of a base amount. As a result, line items on Income Statements are now expressed as percentages of gross sales rather than as precise dollar amounts.

Simply said, it involves scrolling down a single column of data in a financial statement to ascertain how several line items relate to one another (for example, demonstrating the relative amount of various expenses as line items may be listed as a percentage of operating expenses).

Because relative proportions can be seen, this type of analysis makes it simple to compare financial statements between companies, across industries and time periods. You can use it to assess whether performance indicators are getting better.

Even though vertical analysis isn’t always as immediately helpful as horizontal analysis, it can still guide your questioning, such as where costs increased or decreased. What departments are most responsible for profit margins? What effects do they have over time?

Horizontal Analysis

Whereas vertical analysis focuses on each line item as a percentage of a base figure within a current period, horizontal analysis reviews and compares changes in the dollar amounts in a company’s financial statements over multiple reporting periods. It’s frequently used in absolute comparisons but can be used as percentages, too.

The horizontal analysis makes financial data and reporting consistent per generally accepted accounting principles (GAAP). It improves the review of a company’s consistency over time, as well as its growth compared to competitors.

Because of this, analysts and investors value horizontal analysis. A horizontal analysis enables you to identify the factors that have influenced an organization’s financial performance over time and to identify trends and growth patterns, line item by line item. In the end, horizontal analysis is used to spot trends throughout time, like comparisons between Q1 and Q2, rather than showing how specific line items connect to one another.

The Case for Both

When analyzing Income Statements, the issue is not whether to use vertical or horizontal analysis. It should read: How can you most effectively combine both types of analysis to unearth the data you need to make a wise decision? You can gain more insights by combining the two methods than by using only one.

Income Statement Uses

Although the primary goal of an Income Statement is to provide stakeholders with information about the company’s profitability and business operations, it also offers thorough insights into the internal operations of the company for comparison across various industries and businesses. An investor can grasp what makes a company profitable by knowing the income and expense components of the statement.

Management can decide to enter new markets, increase sales, increase manufacturing capacity, use more assets or sell them completely, or close down a department or product line based on Income Statements. Competitors may also utilize them to learn more about a company’s performance metrics and priority areas, such as increasing R&D spending.

Because they are more concerned with a company’s future cash flows than its past profitability, creditors might find Income Statements to be of limited use. The Income Statement is used by research analysts to compare quarterly and yearly performance. For instance, one might draw conclusions about management’s capacity to control operating costs without sacrificing profitability or whether a company’s attempts to lower its cost of sales helped it enhance profits over time.

An Income Statement is used by who?

Users of this Income Statement fall into two categories: internal users and external users.

Company management and the board of directors are examples of internal users who use this data to assess the state of the company and make decisions that will increase profits. Any worries about cash flow might also be addressed by them.

Investors, creditors, and rival businesses are examples of external users. To determine whether to invest in a company, investors look at how well-positioned it is for future growth and profitability. The income statement is used by creditors to determine if the business has sufficient cash flow to service its debts or get additional credit. Competitors utilize them to learn more about a company’s performance metrics and discover areas where it invests more money, like in research and development.

Procedures for Creating an Income Statement

Select a reporting period

The precise time period that the Income Statement pertains to is your reporting period. It’s important to make the right choice.

There are three common reporting intervals: monthly, quarterly, and annual. Your objectives will determine which reporting period is best for you. Since a monthly report, for instance, covers a shorter time frame, it is simpler to make tactical changes that will have an impact on business operations the following month. On the other hand, a quarterly or annual report offers analysis from a higher level, which can assist in identifying trends over the long term.

Determine the total revenue

Once you are aware of the reporting period, figure out how much money your company made overall during that time.

If you create an Income Statement for your entire company, the revenue from every business line should be included. You should only report revenue from goods and services that belong under that particular business line or segment when preparing an income statement for that area.

Calculate the Cost of Goods Sold (COGS)

The next step is to determine the total cost of goods sold for each good or service that brought in money for your company during the reporting period. This includes both direct and indirect expenses incurred in creating and dispensing goods and services, such as:

The cost of labor directly
Materials costs
Expenses for components or parts
Costs of distribution

Any costs that are directly related to the creation of your good or service.

Determine the Gross Profit

The next step is to calculate the reporting period’s gross profit. Simply deduct the cost of goods sold from revenue to arrive at this figure.

Estimate Operating Costs

When you have your gross profit, figure out your operating expenditures (OPEX).

Indirect costs of doing business include operating expenses. These are distinct from the cost of goods sold because they aren’t a direct result of the manufacturing or distribution of goods or services. The following are some examples of costs that fall under the OPEX category:

Rent
Utilities
Overhead
Office Supplies
Legal fees

Determine Income

Subtract operating costs from gross profit to get total income. This figure effectively represents the pre-tax profit your company made during the reporting period. Earnings before interest and taxes (EBIT) is another name for this.

Determine Taxes and Interest

After computing the reporting period’s income, figure out the interest and tax payments.

Any fees that your business must pay on the debt it owes are referred to as interest. You must first be aware of how much you owe and the interest rate is applied in order to compute interest costs. Interest costs for the reporting period are frequently calculated automatically by accounting software.

Determine your overall tax obligation for the reporting period next. This includes any payroll taxes in addition to municipal, state, and federal taxes.

Determine Net Income

Calculating net income for the reporting period is the last stage. To achieve this, deduct taxes from your EBIT first, then interest. The amount left represents your company’s available funds, which can be put to a variety of uses, such as building up a reserve, paying out dividends to shareholders, funding R&D, or expanding your business.

What information in an Income Statement should you look for?

An investor can learn what makes a company profitable (or not) by looking at the income and expense components. They can be used by rivals to assess how their business compares on various metrics. They are used by research analysts to compare quarterly and yearly performance.

What are the Income Statement’s four main components?

Income
Costs
Profits
Losses

A balance sheet or cash flow statement is not the same as an Income Statement.

Example Income Statement

Let’s look at an example to better grasp an Income Statement.

Single-step Income Statement example

You can see from the example above that the association made $30,000 from selling products and an additional $5,000 by charging for training. The association spent money on a variety of activities, totaling $13,450 in expenses. They made $2,000 from the sale of an outdated van, but they lost $1,000 from the settlement of an ongoing consumer lawsuit. Let’s now insert the data in the following equation to determine the net income:

Net Income = (Revenue + Gains) – (Expenses + Losses)

= (35,000 + 2,000) – (13,450 + 1,000) = $22,550

One of the most basic types of Income Statements is the one shown above, where the net income is calculated by adding the values of income, expense, gains, and losses to the equation. It is known as a single-step income statement since it is based on a straightforward computation.

Multi-step Income Statement example

In the actual world, businesses that conduct their operations on a global scale offer a variety of goods and services and engage in mergers and alliances. They have a long list of activities and expenses to mention as a result of these activities. Additionally, these businesses must adhere to specific reporting laws. Therefore, larger businesses choose multi-step income statements. operational revenues, operational costs, and gains are distinguished in this approach from non-operating costs, non-operating revenues, and losses. The four levels of profitability are gross, operating, pre-tax, and post-tax. The single-step income statement’s company information is used in the example above.

A company’s Income Statement is a valuable source of knowledge about the important elements that contribute to its profitability. Because it is generated much more frequently than any other statement, it provides you with timely updates. An equation can be used to determine a company’s net profit or loss for a given time period by plugging the expense, income, gains, and losses from the income statement into the equation. This information aids in the timely decision-making necessary to maintain the financial stability of your company.

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