Understanding Income Statements
If you are part of the business world, you need to be aware of some of the financial statements companies are required to produce. If you’ve heard people talk about profits and losses, the chances are they are talking about an income statement. For people who haven’t gone through accounting school, these statements can be all Greek.
But understanding income statements is vital for anyone who’s involved with the business world – whether you are an aspiring business journalist, a small business owner or an investor.
This guide is going to explain 1) the basics of an income statement, 2) help you understand the terminology used in these statements and 3) provide you with tips for analysing income statements.
WHAT IS AN INCOME STATEMENT?
An income statement is an essential part of a company’s financial records. The official definition says an income statement is:
A financial document generated monthly and/or annually that reports the earnings of a company by stating all relevant revenues (or gross income) and expenses in order to calculate net income. Also referred to as a profit and loss statement.
In essence, the income statement looks at the financial performance of an entity over a specific period in time. It provides the entity a summary of the revenue and expenses by looking at operating and non-operating activities.
In most instances, an income statement looks at the net profit or loss of the entity over a fiscal year, but in certain instances, this could also be a quarter or even a month.
In crude terms, an income statement is divided into two sections:
- The income coming into the entity
- The expenses going out of the entity
The two sections are then combined to show whether the entity is making a profit or a loss.
Who gets and uses an income statement?
Publicly traded companies must provide income statements, as well as balance sheets and cash flow statements. For these companies, the income statements must be publicly available for the general public at any given time. In addition, other companies and entities also create income statements, although they are not necessarily publicly published.
The basics of the income statement remain same from business to business, but there are differences within the sectors depending on the industry and the type of business in question.
In essence, any entity that makes money will use an income statement. But business’ income statements are also essential for investors, as they provide financial information on the business and can therefore influence investor decisions.
Why are income statements essential?
While income statements are often required by law for accounting purposes, they do also provide plenty of essential information for businesses. Therefore, an income statement shouldn’t just be considered as unavoidable, but also as an important part of improving the business’ finances.
Income statements are important for any entity because they:
- Provide vital financial information – you can quickly establish how well the business is doing in financial terms and whether it is profitable. Furthermore, as mentioned above, the information is not only vital for the business entity, but also for investors.
- Shows trends in the business’ finances – business entities can collect their income statements over a long period and by comparing them, learn a lot about the business and any possible trends behind the business’ finances. This can help the business to improve profits and grow the business.
A TYPICAL INCOME STATEMENT FORMAT
In order to make the most of the income statement, whether as investor or business owner, it is important to understand the income statement format. The good news is income statement formats are relatively generic, although there might be slight differences between countries as well as the sectors the business operates in. You can find out more about the differences between countries later on in the guide.
In general, an income statement is divided into two parts: the operating and the non-operating sections. Both of these sections will look at the revenue and expenses of the business, with:
- The operating section focusing on the revenue and expenses associated with the business’ normal, everyday activities. For instance, the costs associated with making of the goods the company sells are part of the expenses in the operating section.
- The non-operating section informs of any revenue and expenses that are outside of this normal, everyday activity. For example, the business might at some point sell some of its investments, which is considered as an occasional income.
In terms of formatting, it is possible to have the income statement produced either in:
- Single-step format, or
- Multi-step format.
The multi-step format is often the most professional option, mainly because it clearly states the different profitability measures of the business, which are not included in the single-step format.
These four profitability measures found in the multi-step format include:
- Gross income,
- Operating income,
- Pre-tax income, and
- Net income (after tax).
This differentiation is not available in the single-step format, although it can naturally be calculated with the data provided by the income statement. The single-step format will show profitability in terms of:
- Pre-tax income, and
- Net income.
The formats are often chosen depending on the size of the business. For example, a small business with very clear revenue and expense streams can manage with a single-step format. On the other hand, a larger company, with different revenue and expense streams, might want to consider a more detail approach to the income statement.
Terminology used in income statements
In order to understand income statements, you need to understand some of the common terminology used in the statements. The following might not be present depending on whether the format is a multi-purpose or a single-format, but they can be found in most income statements
The first part of the terminology focuses on the revenue aspect of the income statement. The revenue is often the first thing announced at the top of the income statement. The following are the key revenue-related terms.
This refers to the entity’s sales or revenue and highlights the company’s sales of goods and services during the fiscal period.
The part is often a good indicator of the company’s profitability, as most businesses won’t be able to grow faster than their revenues. For investors, it is important to also keep an eye on this part.
The next section of the income statement typically looks at the expenses of the business. It is good to remember income statements don’t differentiate expenses and revenue with a minus sign. Therefore, understanding the meaning of the terms is vital in order to understand whether the business is making or losing money.
The following are the key expenses-related terms of the income statement.
Cost of sales
This section highlights the costs of goods or products sold, as well as the cost of services provided by the entity. Cost of sales generally also includes the depreciation expenses.
For manufacturing businesses, the cost of sales is often related mostly on the creation of the goods. It is the combination of the expenses relating to raw materials, labour and manufacturing.
Wholesalers and retailers also focus on the cost of purchasing and reselling the goods or products. On the other hand, for service-related businesses, the section looks at the cost of creating and providing the service to customers. This is often especially focused on labour costs, for example.
The cost of sales can be divided into more detailed sections. For example, the business could list the cost of labour separately to the cost of business premises.
Selling, General and Administrative expenses (SG&A)
The SG&A section of the income statement comprises the operational expenses of the business. It shows the managerial efficiency of the business.
This part of the statement is often the most looked at, as financial analysts believe businesses are the most able to control it. If businesses want to decrease their spending, then this is often considered the easiest part of cutting costs.
If the business has borrowed money, the interest expense section deals with any interest payments the company might have. Generally, businesses record a net figure here for interest expenses as well as the interest-related income businesses might receive from investing in funds.
The income tax announced in the income statement doesn’t necessarily refer to the actual paid tax. It is rather an estimation of the income tax for the period and shows what the company is likely going to have to pay.
Special Items or extraordinary expenses
There might be a variety of occasional expenses businesses might need to pay. These could be restructuring charges or unusual and non-recurring items.
These one-off events need to be carefully considered when looking at the business income. It is important to understand that they could potentially distort evaluations, as the one-off events might not actually mean the business is making a regular loss, for example.
Finally, the bottom of the income statement looks at the profits or losses of the company. This part of the statement will be calculated based on the information above and depending on the format of the statement, it can include single income figures or different profitability indicators.
The following are the key profit or loss-related terms of the income statement.
Gross income is often referred to also as gross profit or gross margin. Simply put, the figure represents what you get when you calculate the difference between net sales and the cost of sales.
Gross income is the amount of money the entity has available for paying off other expenses the company might have. Therefore, the bigger the gross margin, the higher the net income is likely to be.
Operating income is achieved by deducting the SG&A from the gross income. Operating income is the income, the entity has been able to generate before any non-operating expenses and costs are deducted or added. None of the occasional income or expenses is included in the operating income.
The operating income is often a crucial figure for investors, as it tells a more reliable picture of the company’s earnings than the net income, for example.
Pre-tax income is another crucial indicator of the company’s health for both the business owners as well as the investors. The section is rather self-explanatory, as it refers to the income the company makes before taxes are deducted.
The figure is crucial because companies have different methods and techniques at their disposal to minimise their tax burden. Therefore, this figure can be a better indicator of the company’s real profit capability.
Finally, perhaps the most crucial aspect of the income statement is the bottom line or the net income section. This is the section where all operational and non-operational revenue and expenses are calculated. If the company’s revenues are bigger than expenses, the entity naturally makes a net profit. If the expenses are higher than the revenue, the company is making a net loss.
In addition to the above, the multi-step format can also talk about comprehensive income. This term is relatively new and many income statements don’t include this concept.
Comprehensive income first entered income statement formats in the 1998 in the US. It’s the most useful for international companies and other such large-scale businesses.
It takes into account the effect of items such as foreign currency translation adjustments, as well as minimum pension liability adjustments and unrealised gains/losses on certain investments the company might have in debt and equity.
Things such as market volatility and other such economic events often influence the above items and are outside of the management team’s control. Therefore, many investors don’t think the comprehensive income tells much about the company’s actual profitability.
Differences in standard formats
To make the above format and terminology seem more familiar, below are examples of both styles.
A single-step income statement
Gain on sale of investments
|Cost of sales|
Selling, general and administrative expenses
|Income tax expenses||215,000|
A multi-step income statement
|Cost of sales||250,000|
|Selling, general and administrative expenses||125,000|
|Income tax expenses||215,000|
Differences between countries
The above examples, as many of the terms mentioned above, refer to the standard model for income statements used in the US. The US model is commonly used elsewhere in the world, but there can be slight differences between countries.
Countries have been trying to standardise these accounting formats in recent years and the good news is the basic structure is easily identifiable across countries.
Often the differences between different countries are only in terminology. For example, the British income statement refers to ‘turnover’ instead of ‘revenue’. Furthermore, instead of saying ‘Net income’, the statement might refer to ‘Profit after taxation for the year’.
ANALYSING AN INCOME STATEMENT
The above terminology and examples should give you a basic understanding of the income statements. But there are certain other things you need to keep in mind when you are looking at and analysing an income statement.
Here are some of the key things to keep in mind when you are trying to make out what the income statement is saying.
Understanding the numbers
As mentioned above, the income statement will reveal some key financial information for you about the company’s performance. It is vital all the numbers on the income statement are correct. If you’re the business owner, you need to go over the numbers to ensure they are correct. As an investor, you might not have the resources to recheck the numbers, but make some basic calculations and estimations to ensure the data is correct.
You need to identify the key profitability indicators that matter to you the most and analyse them. Gross margin, for example, is the first indicator of whether the business product or service is profitable. On the other hand, the operating profit will reveal how efficiently the business is managed and whether it should consider cutting operating expenses. Finally, the net income might be the most important figure for an investor. It provides the final verdict on the profitability of the firm.
In addition, you should also look at the development of the figures in the income statement over a certain period. As an investor, you want to know how well the company has managed to increase its sales over the years and to grow its net profit. On the other hand, as a business owner, you must be able to see whether your business is growing and if certain expense cuts have proved a success or a failure.
Comparing it with others
Whether you are an investor or a business owner, it is important to compare the business’ income statement with other similar organisations. This can reveal a lot about how well the business entity is doing against other companies in the sector and reveal which areas of your business might require special attention.
Small- and medium-sized businesses might have trouble accessing income statements for other similar companies, as the statements are only required to be public for publicly traded companies. But certain firms sell financial statement studies, which can reveal a lot of crucial information, and big accounting firms might also have some data available.
Make sure you don’t just compare the actual amounts, but also the percentage of how specific revenues and expenses relate to each other. For example, it is important to see how much similar companies in the industry are spending on SG&A as a percentage of revenue.
The importance of accounting methods
The accounting methods the business uses can have a big impact on the income statement. Companies can, for example, have different methods of determining revenue. Some businesses use the cash method of accounting, which only accounts for income when the cash is received. On the other hand, there are businesses that consider all billed cash as income, whether or not the cash is received at the time of creating the income statement.
Furthermore, similar accounting differences can also appear in the expenses section. Expenses such as depreciation and the way the company accounts for these can have an impact on the company’s annual expenses.
When you are looking at an income statement, you need to identify the areas where companies might have used discretion. Depending on whether the company uses aggressive or conservative accounting methods, the income statement might look different.
In San Jose (CA), we meet Co-Founder & VP of Technology of Aquantia, Ramin Farjad-Rad. Ramin talks …