The Income Statement Explained
The Income Statement is one of the three main financial statements, along with the Statement of Cash Flows and the Balance Sheet (there are also Statements of Comprehensive Income and Statement of Stockholders’ Equity). Depending on who you talk to you will hear the income statement called a number of different names like. Profit & Loss, P&L, Statement of Earnings, Statement of Income, and others.
Simply put, the income statement is a summary of a company’s revenues and expenses over a period of time. The concept of “over a period of time” is important to remember, and is a key difference between the income statement and the balance sheet. The income statement tells the reader how profitable the company was on paper.
Throughout this site we default to talking about accrual accounting unless otherwise specified, so when we talk about the income statement here we are talking about the accrual concept of income. This means we aren’t talking about cash flow and when we get paid or when we pay someone else. Revenue won’t just equal cash in the door. A few examples,
- In the business world it is common to sell a good or a service and then give the customer 30 days to pay. You would have revenue before you received the cash
- The flip side of this is also common where a business may buy a product but not have to pay for it for 30 days, so they would have an expense before they pay out the cash
- In general, an accrual-based income statement will try to match and make sure the revenue and expense related to that revenue occur at the same time.
Details of the Income Statement
Above you can see an old example of Microsoft’s Income Statement from their financials. Let’s walk through the components of the income statement.
Revenues are effectively inflows from a customer for either delivering them a product, providing them a service, or some other activity that is core to the business (something like selling an old asset would not qualify as revenue). This may also be shown as Sales or Net Sales or some other terminology. This is the first line on the income statement.
Most businesses split their revenues between product sales and services and financial firms and banks are a little different in that they will often show interesting income and non-interest income or something similar.
Revenue is required to recorded when the ownership of the product passes on to the customer or when the service is delivered in completion.
Cost of Goods Sold
Cost of Goods Sold (or COGS) is the next item on the Income Statement. These are the direct costs of the business. These are the costs that are directly attributable to the sale. It answers how much cost did it take to deliver your product or service. The key word here is “direct” it does not include costs that are indirect like the salary of a CFO for instances.
Remember, we are talking accrual method of accounting, so these costs need to be recognized in the same period as the revenue.
For a manufacturing business the main things that will hit your COGS accounts are direct labor, direct materials, and overhead. So this is things like the salary and benefits of the employees that work in the manufacturing shops, the raw materials that go into the product, and the overhead of running the operations.
For a service business the COGS would be the cost for employees working directly on a client engagement
For a retail business this would include the purchasing cost of the item and any other costs directly related to getting that product ready to sell to the end customer.
Gross Margin or Gross Profit (they are the same thing) is simply Revenue minus COGS. This is the money that is left over after a product or service is provided. Gross Margin tells you how much margin you made before all the costs you need to incur to sell your services/products, to develop new products, to grow the business, and more.
Higher gross margin % is obviously better, but gross margins are highly variable based on which industry you are in. Also, gross margins typically get better as a company grows (they start to get things like scale with suppliers, etc).
Operating Expenses (non-COGS)
These are all the expenses beyond Cost of Goods Sold that a business needs to run and grow the business (non-production expenses). You may see this broken down into a few different sub-groupings like: Selling, General, and Administrative Costs (SG&A), Research and Development (R&D), and Other Operating Costs.
SG&A Costs are the costs to market and advertise the product or service, the management salaries (CEO, CFO, etc), expenses for professional service firms (like lawyers, accountants, contractors/consultants), rent, insurance, utilities, supplies, travel and entertainment, and more.
R&D Costs are the costs related to finding or developing new products or services
Other Operating Costs are just costs that don’t fit cleanly into the other buckets, it is a catch-all.
Operating Income is Revenue less COGS and all Operating Expenses. Simply put, this is all your Income form Operations. It is what is remaining after all expenses. This is the same as Operating Profit, Operating Margin, and EBIT.
Other Income is non-operating gains from non-core activities like selling a long-term asset, or income from a subsidiary. Sometimes you may see gain/loss on asset sales as it’s own line item on an income statement.
Interest expense is a non-operating expense related to the cost of borrowing. Borrowing money is not core to a company’s operations so it is a non-operating expense (unless the company is a bank or financial institution).
Income Tax / Provision for Income Tax
Income Tax is the amount a company pays out (or estimates it will pay out) for a given period.
Net Income or Net Earnings
This is what is left after all expenses, interest, and taxes. This is the “bottom line” as it is often called. This is ultimately something most companies are measured to.
The Income Statement you will actually see in your company
So that is the income statement in its most formal form, but in reality what you are going to encounter in your day job is a “management reporting” income statement that shows products, regions, divisions, segments, or something else.
The income statement is more than just a formal reporting statement that public companies disclose, it is a tool used to assess profitability. If you look at an income statement in a more detailed form it can show you a lot. The deeper you go, the more you may learn. For example, if you can look at an income statement for a particular customer or product, this can give you great insights. You can compare products and customers pricing and cost-footprints.
What you see in that management reporting income statement is unlikely to go all the way down to the net income level, more likely it will be abbreviated and show only to the gross margin level or maybe down to operating profit.
How is the Income Statement useful and what are the Income Statement limitations?
Reasons why the Income Statement is useful
- First off, the P&L is useful to investors, creditors, the company, or anyone else analyzing a company.
- Due to the accrual concept of accounting, looking at cash flows alone won’t tell you the whole story. Especially as you look at long term contracts or something like a company with annual subscription models, seasonality, or other non-transactional businesses.
- The P&L is used to evaluate past performance to understand profitability, investment in future technologies, and much more. There are a number of financial ratios and analysis that can be used on the income statement alone or in conjunction with the other financial statements
- Using the income statement is one way to predict future performance and to create realistic forecasts based on how they have traditionally performed and any future clues that can be garnered from the financials.
- Often financial statements like the P&L can be used to evaluate if there is risk to achieving future cash flows. The income statement, particularly several years of income statements) can give info on if product costs are rising, if the company is spending too much on sales & marketing or research & development.
- The income statement can be a useful comparison tool to measure similar companies in similar industries.
Limitations of the Income Statement
While there are many uses of the Income Statement, there are also several limitations.
- All the data in the P&L is backward looking, it is all historical. You can sometimes get clues of the future, but ultimately it is all backward looking. Even the latest quarterly or annual income statement may be months old by the time it is published
- There are intangible elements that can’t be properly valued like brand value, customer loyalty, intellectual property and R&D. These can have tremendous future value that have not yet manifested.
- Some numbers in the financials are based on estimates or on judgements like depreciation, accruals, or even how a company classifies expense (COGS vs. SG&A, etc)
The Income Statements published by large companies for external use lack detail. On the flip side, as mentioned above, internal management reporting income statements can get very detailed and be quite useful! – Occasionally financials have unusual items or anomalies that skew results (although hopefully the Management Discussion & Analysis or the Footnotes give some context for these).