What is an Income Statement and Why Should You Care?

Every businesses’ primary purpose is to earn a profit. Stockholders or investors invest their resources in running a business to maximize profit. In order to monitor the status of their investments, they use financial statements to get a clear picture of the company’s financial performance. One of these statements is the Income Statement.

The Income Statement, also known as Profit and Loss Statement, shows the profitability of the company, it shows revenues earned and expenses incurred on a specific period. This report is an important tool used by the management in their decision-making process. By comparing the income statement of different periods, business owners are able to assess the business’ performance over time; Is it doing well? Is the company losing? Or is it earning just enough to cover the cost? Using the information provided by income statements, the management is able to point out expenses that use a huge chunk of revenue and may try to reduce these expenses through different alternatives.

5 Main Components of Income Statement

The Income Statement has 5 main components. Each component provides information about your business performance:

1. Gross Sales or Gross Revenue – It is the total amount earned by the company by selling its products or providing service to customers and clients.
2. Cost of Sales or Cost of Services – Another term used is “Cost of Goods Sold”. This is the total amount of expenses directly attributable to acquiring or manufacturing products which the company sells, or expenses directly attributable to providing services.
   
   Expenses under this component varies in different businesses, below are some examples:
   • Manufacturing – This includes direct labor, direct materials, and direct overhead 
   • Merchandising – Usually includes the cost of the product purchased for resale and shipping charges 
   • Service Industry – Includes salary of staff directly involved in the performance of service and other expenses directly related to rendering the service such as depreciation for the leasing company
     
3. Gross Profit – Total amount earned after deducting the cost of goods sold / cost of services. It shows how efficiently the company uses its resources in producing its goods and services. Some companies use the gross profit margin in the determination of their selling price, they adjust the selling price to reach the desired gross profit.
4. Operating Expenses – Also known as general and administrative expenses. These are expenses incurred in the general running of the business; this includes administrative salaries, office supplies, advertising, utilities, and others. An increase in operating expenses would mean a decrease in net profit.
5. Net Income or Loss – It is the net amount of revenue earned after deducting all expenses in a given period. Net income results in an increase in equity which can be paid out to investors or owners. While a net loss would result in a decrease in equity.

To get a better understanding of the 5 main components mentioned above, here is an example of an income statement:

Reviewing Your Income Statement

The usefulness of the income statement depends on how well you examine the statement. It may be just another report unless you know what you are looking at. Below are some guidelines that will help you in reviewing your income statement:

• Do the Math
  Just a little checking if the amounts are accurately presented. No worries, as it does not require you complicated math equations. You may check the amounts by adding all items under the Cost of Sales and Operating Expenses to ensure the total are correct or Deduct Cost of Sales from Gross Sales if it matches the Gross Profit.
  
• Identify Net Income or Loss
  By looking at the bottom line, it will automatically give you an idea of how well the business performed. A positive amount or a net income would mean that the business is doing well, it means that the business is earning more than how much it cost it to run. A negative amount, or a net loss, on the other hand, would indicate that the business is spending more than its revenue. A net loss does not necessarily mean that the business is going to bankruptcy, there are factors that may contribute to this which can be improved in future periods, hence the importance of studying the income statement.
  
• Evaluate Sales and Revenues
  Assess if total revenues earned for the period is sensible for the business. For businesses with more than one source of revenue, identifying revenues earned from each source would help understand which source provides more revenue.
  
• Examine Expenses
  Expenses vary in different business types. Examine each expense item as there may be items are that are inappropriate for your business or expense amounts that are higher than it should be. Look for an explanation on these items, you may be paying expenses you don’t need to. Identify any one-off big expense that could greatly impact net income for the period.
• Compare Different Period Reports
  Income Statements are usually prepared on a monthly, quarterly, or annual basis. Comparing the numbers from different periods enables you to see the trend. Is sales increasing? Is the company incurring net loss for more than one period? Is there any significant increase in a particular expense item? Comparing multiple periods determines if the business is improving or getting worse.
• Compare Statements of Different Profit/Cost Center
  Companies usually have different departments within the organization which are essential in running the business, and some have branches generating revenue from different locations. These sub-units of a company are called profit centers or cost centers. A profit center is responsible for revenue generation while cost centers do not directly add to profit but still costs. Medium and Large companies usually prepare an income statement for different profit/cost center. Through comparison, it will help you identify which sub-unit generates more sales and which sub-unit has a significantly high expense.
• Conclusion and Planning
  After reviewing the areas stated above, you will be able to draw a conclusion on the overall performance of the business within the period. Use the information you have gathered in a further examination, planning, and decision-making.

For deeper understanding and analysis, you may seek assistance from your accountant or financial analyst to help you interpret the report and give you advice on how to improve your business performance. A favorable income statement attracts more investors, it is a proof of business success.