The income statement is one of the most important financial statements.
It is not just a statement listing out the income details of a company.
In many ways, it is one of the most crucial documents to assess a firm’s financial health.
It is the broad summary of the variety of revenue inflow and potential income avenues.
This is why often it is the most important representation of the future potential
It lines out the kind of income that a company has.
It is also an indicator of the kind of revenue you can expect in future.
After all, we always refer to the financial health of a firm before investing in it.
Depending on the kind of income projection a firm has, you can take a call on future.
It will help you outline the type of growth a company may see in future.
On the whole, the income statement gives a broad view of the average growth outlook.
For example, if you are a VC looking at potential investment targets, you will refer to the income statement.
This is by far one of the most important documents to refer to.
It highlights the firm’s potential to generate long-term income.
So, it will help you get a fair idea of the kind of returns you can expect.
It will also help you assess investment opportunity in the particular firm or sector.
Most importantly income statement is similar across industries.
So you do not need any special skill to decode this statement in a comprehensive manner.
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Definition of Income Statement
So how exactly should we define an income statement?
In many conditions, it is also termed as the ‘P&L’ statement or the profit and loss statement.
So you can well imagine, it the detailed account of the revenue generated and expense incurred.
In fact, this is amongst the most important financial data.
It figures prominently in any company’s annual report.
Also, it is an important and an integral part of all legal transactions.
Furthermore, it is one of the best representation of a company’s financial affairs.
It is the only document that gives a broad view of both the sales and the income.
The income statement can be very specific too.
It does not just offer a picture of the annual income, but also small time periods.
You can even break it down into smaller units.
The lowest of the lot is undeniably the earnings per share or the EPS value.
So an income statement helps you in ascertaining the valuation to the smallest level.
Normally an income statement has two fundamental parts.
It is divided into operating and non-operating parts.
As you can understand, the operating statement gives you details of the direct revenue flow.
This also includes the expenses that you may have incurred to fund the regular operations.
The non-operating part of the income statement covers all the other expenses and revenue sources.
Let me use an example to clarify my point.
Let us assume I have a bakery business.
I earn x% profit every month.
The operating part of the income statement will list out the revenue and expenses incurred in making and selling the product.
But I have also been investing a part of the profit every month.
The income from that will then be part of the non-operating segment.
Earnings Component Of Income Statement
So what are the primary parts of the income statement?
There are many elements to provide the complete revenue a list.
In very simple terms, it is the money that you get from the sale of various products.
Whatever the company has to offer, this records the desired income flow.
In many statements, there are other related terms like sales, net income that are used.
Most statements refer to it as ‘top line’.
It completely highlights the overall revenue picture.
Every penny that comes in is accounted for under this head.
This is an essential component of any income statement.
In very simple words, it is the essential money you can make after covering the input cost.
So it is revenue minus every imaginable expense.
This will also include tax liabilities and administrative costs, wages and all such elements.
This also includes non-cash entities like amortization and depreciation.
Now this is where the income statement gets to specifics.
This is the difference between the revenue and the cost of goods.
So this helps readers get a better idea of the actual profitability of the business.
This figure also has a bearing on the overall margins.
This is what you get when you subtract the cost of goods and operational expenses from the key revenue.
This is why it is also referred to as earnings before interest and taxes, the EBIT number.
Expense Components Of Income Statement
Here is a quick summary of the overall expenses in the entire statement:
Cost of Goods Sold
This is one of the most important expenses incurred.
It is the direct cost of every single product that is put up for sale.
So this includes the material cost, cost of labor, resource mobilization, machinery, etc.
It fairly details out every penny that is spent in the creation of the product.
Operational costs are also an important expense for a business.
Often the amount of research work done, the type of administrative expenses incurred fall under this head.
In short, it is every single expense that is important to keep the business operations.
From the smallest stationary to the electricity cost, it includes all.
Even the patent filing expenses and other legal documentation is part of this expense.
It refers to the depreciating value of the machinery and the other tools that are required for production.
Every asset that the company owns for a long time has to be valued as per current rates.
The income statement carefully records every small detail regarding that.
Now this is a unique element that is mentioned in both the expense and income list.
As the term indicates, it is every other income or expense that is incurred by the business.
You can have interest income or expense, the tax expenses or refund, and many similar miscellaneous items.
These are also crucial data points and form an important part of the overall income statement.
Why Do We Need Income Statement?
Well, I mentioned right at the behest that an income statement is necessary to understand the financial condition.
But is that the only purpose or utility of an income statement?
Well, this statement is a key financial data point for many different types of analysis.
Research analysts use this statement to calculate many important financial ratios.
These include the
- ROE or the return on equity
- ROA or the return on assets
- EBIT numbers or earnings before interest and taxes
- EBIDTA or earnings before taxes and amortization
So, in short, every small and big financial ratio takes this number into consideration.
Analysts can also break up the individual elements into percentage format.
This helps in assigning what expenses made up the maximum chunk or what income was the key element.
In short, it provides the most relevant profitability analysis.
Most importantly the income statement is never for a specific time period.
You can refer the data from the previous quarter or even financial year.
A typical income statement will at least offer 2-3 years of historical data.
That plays a very important role in analyzing data matters especially when you are drawing up the comparison between multiple companies.
For many active investors, these comparisons are the primary pillars of a great investment.
It helps them in thoroughly investigating the overall financial health of the firm.
The EBIT and EBITDA numbers also bring a more realistic assessment of a firm’s debt liability.
Therefore, it just does not tell you about the current debt but also about the future liabilities.
This is because the future interest cost will also depend on the company’s ability to generate revenues.
As a result, the income statement gives readers a comprehensive view of the overall financial strength of the business.
How To Format An Income Statement?
So now the question is how to compute the income statement?
It sure is a record of some of the broad expenses.
But there is a set format to write it.
In fact, the income statement does not differ with the industry.
So there are two primary ways of formatting it.
Single Step Method
This is decidedly the most basic formatting type.
In this, all the revenue is added and then subtracted from the expenses.
In one single step, as the name implies, you get your income account and profit data.
So you can well understand that this is a straightforward and uncomplicated way to compute profit.
But this will work only in the select situation.
Many times, you may have to furnish more details than that.
In this case, you need to calculate quite a few things.
The bottom line is actually the final bit of the entire income picture.
Needless to mention, it is a fairly more time-consuming format.
You have to first jot down the operating expenses and the gross profit.
After that, the operating cost is subtracted from the gross profit.
You get the operational income.
After this, you will have to subtract the other expenses and add the other income.
So you get the overall profit before taxes.
You can subtract the tax liability from it to get the actual profit after tax.
This is the net income or the actual bottom line.
This is by far more specific, and as a result, the income statement is more detailed.
That is often very important when you are calculating key ratios.
A broad addition and subtraction as in the single step format do not work effectively for much detailed analysis.
The multi-step format is, therefore, more accurate.
How Is Income Statement Different From Balance Sheet?
We have already mentioned that the income statement is one of the three most important financial documents.
The question is how is it any different from the balance sheet?
The balance sheet is also an account of profit and loss.
The balance sheet too accounts for the operating costs and margins.
But, it is still not the same as the income statement.
There are some unique differences between the income statement and the balance sheet.
On the whole, you will notice that a balance sheet is an account of assets, liabilities and equity.
Overall the assets include the investments, both short and long-term and assets.
They also include the liquidity and the receivables by a business.
This also accounts for fixed assets like real estate and long-term ones like Fixed Deposits.
So in short, assets both tangible and intangible are listed under this head in a balance sheet.
The investor looks at each and every value and then adds them together to get the final value.
Now, what does an income statement do?
Just like balance sheet, it is also an account for the overall current valuation.
The actual worth of the business is manifested in the income statement.
The income and expenses are listed under operating and non-operating parts.
It essentially deducts every expense from every revenue source.
In step by step process, you get the net income.
That essentially means you have to keep excluding the other expenses.
The other income too has to be included in a systematic manner.
When all these numbers are computed together, then you get the final net income number.
This, therefore, means you have to study the balance sheet and the income statement together.
Proper analysis of both will enable an effective assessment.
How Is Income Statement Different From Cashflow Statement?
The question is what is the basic difference between the income and cash flow statement?
The cash flow statement records cash usage for a business during a specific period.
The income statement, on the other hand, measures the overall financial performance during a period.
The cash flow statement is very specific in this context.
It will provide exact details of cash generated and used.
The most basic computations are for a month, and it keeps increasing thereafter.
So, as a result, it highlights the current transactions and all potential changes in the balance sheet.
So, cashflow statement records any increase or cut in the amount of receivables.
However, the non-cash components are not specified in the cash flow statement.
So, it is a better reflection of the short-term liquidity consideration of a business.
The overall funding required and used in a shorter period is captured quite accurately.
The result is that several other elements like amortization and depreciation are not recorded here.
These are non-operating expense elements.
But at the same time, you cannot assess profitability properly without these figures.
So if you are trying to analyze if the business is capable of addressing daily expenses like labor wages and the like, it is the key data to look at.
However, the income statement is broader based.
It records revenues, total expenses and other related costs.
So, be it the depreciation rate or other non-cash elements, this is a better reflection.
It provides a distinctly longer-term viewpoint when you compare with the cash flow data.
It can also differ and can include longer time frames.
As a result, this gives a better assessment of the company’s financial performance.
So if you are keen to understand the financial strength of a company, the income statement provides a better analysis.
An income statement well represents the success or failure of the business.
The main goal of computing this statement is to highlight the quality of business in pure numbers.
When your income statement shows steady revenue and profit, there is something else that you should know.
It highlights how successful the average quality of the business is.
Normally this income statement is computed on a monthly basis.
That means that it can be extremely specific, and highlights development over a limited period.
So if you are keen to analyze a business’ financial strength, the income statement is a reliable option.
The income statement well represents overall earnings, profit and loss.