understanding-the-income-statement-for-beginners

Understanding the Income Statement

The income statement is one of the main financial statements for a business. We also touched on the balance sheet and how it shows the overall health of the company at a specified period.

The income statement, also known as a profit and loss (P&L) statement, differs as it shows shows the movement of cash and the business’s profitability. The statement indicates how the revenue results into the net income. The income statement reports on the making and selling activities during a period of time. All business activities that generate income or result in a loss for a company is reported on the Income Statement.

The basic equation of the income statement

Sales – Costs & Expenses = Income

Two Basic Formats of the Income Statement

There are two basic formats for the income statement that are used in financial reporting presentations; 1. multi step 2. single step. What’s the difference between the two statements? In the multi step income statement, there are four elements that reflect profitability; gross, operating, pretax and after tax.  In the  single step income statement, the gross and operating income figures are not stated but they can be calculated from the data provided.

Single Step Formatted Income Statement

Net Sales

Materials and Production

Marketing and Administrative

Research and Development Expenses

Other Income and Expenses

Pretax Income

Taxes

Net Income

 

Multi Step Formatted Income Statement

Net Sales

Cost of Goods Sold

Gross Margin/Income

Sales & Marketing, Research & Development, General & Administrative Expensesunderstanding the income statement

Income from Operations

Other Income & Expenses

Pretax Income

Taxes

Net Income

Financial Income Statement Example

Financial_Income_Statement_Example

Download in Excel

 

Understanding what makes up the Income Statement

Sales or Revenues are recorded when a business actually ships products to its customers; not when cash is exchanged.  After the customer is shipped the product, they have an obligation to pay for the product and the company that produced the product has a right to collect its funds. If the product is paid on account, then it will show on the Balance Sheet in accounts receivable.

Net Sales is reported on the Income Statement. This amount is what the company will receive for the product. The net sales amount includes the list price minus any discounts offered to the customer. This is known as the “top line” revenue as the income process begins here.

Please note that orders and sales don’t mean the same thing. Orders aren’t guaranteed income, they just represent a strong interest to buy. Orders, however, turn into sales and is reported on the Income Statement.

Costs are what you spend to make a product for inventory. Costs include raw materials, manufacturing overhead, worker’s wages, etc. When inventory is sold to a customer, the cost is taken out of inventory (on the balance sheet) and entered in the Income Statement; this is called cost of goods sold (COGS).

The COGS is accumulated in inventory until the product(s) are sold. Once sold, they become expensed and shown on the Income Statement.

Gross Margin (gross profit or manufacturing margin) is the amount left over from sales after cost of goods sold are subtracted. The greater and more consistent the gross margin is, the more potential there is for a positive “bottom line” or net income.

Net Sales – COGS = Gross Margin

Expenses are the expenditures that don’t associate with making a product. Expenses pay for developing and selling products and the administration side of the business. Examples of expenses are sales salary, research and development, legal fees, buying office paper, etc.

Operating Expenses (SG&A – sales, general and administrative) are expenditures that a company makes to generate an income. Typically, financial analysts assume that there is great control over this category and therefore it is watched very closely for signs and trends. The trend of SG&A expenses, as a % of sales, affects managerial efficiency positively and negatively. Operating expenses include;

  1. Sales & Marketing expense
  2. Research & Development (R&D) expenses
  3. General & Administrative (G&A) expenses

Income From Operations is what is left over after expenses and costs are subtracted from the net sales. This amount reflects a company’s earnings from its normal operations before any non-operating income or expenses takes place.

Gross Margin – Operating Expenses = Income From Operations

Non-operating Income & Expenses are the aspects of an organization’s income and expenses that are derived from activities not related to its core operations. Non-operating income includes such things as dividend income and investment gains. Non-operating expenses include interest charges and costs of borrowing.

Net Income (net profit or net earnings) is simply the sales less any costs and expenses associated with a company. This is also known as the “bottom line.”   The “bottom line” is a common indicator for profitability. Also note that a company can be profitable but be insolvent (no cash to pay expenses).

Accrual vs Cash Basis Accounting

There are two ways accounting is handled for a company. Most businesses use the accrual basis which is when income and expenses are recorded when the transaction happens, not when cash trades hands. Cash basis accounting is recorded when cash is spent or received, this is the simplest accounting. In our definitions above, we considered the accrual basis as it is required by the IRS if a business maintains inventory for products to sell.

How the Income Statement & Balance Sheet are Linked

If a company’s Income Statement shows a net income then the retained earnings are increased on the Balance Sheet. In turn, there must be an increase in assets or decrease in liabilities on the Balance Sheet to remain in balance. Therefore, the Income Statement represents a period where all business activities will increase assets or decrease liabilities on the Balance Sheet.