Income Statement Definition
An income statement is a financial report that summarizes the revenues and expenses of a business. This document gauges the financial performance of a business in terms of profits or losses for the accounting period.
The income statement follows a specific format. First, sales and revenue figures are recorded right at the top, which is followed by other income streams. Only then are the expenses deducted from total income. Ultimately, the document reveals the net profit/loss accrued by the business.
Table of contents
- An income statement is a profitability report. It records revenues, gains, expenses, and losses to evaluate net income.
- This financial report follows the following formula:
Net Income = (Revenue-Expenses) + Gains-Losses.
- Shareholders, investors, lenders, and competitors use this document for interpreting and comparing financial performance.
- It is the same as the profit and loss account that reflects the final income of a firm. However, it is entirely different from the balance sheet. A balance sheet, on the other hand, is a purview of corporate assets and liabilities.
Income Statement Explained
An income statement summarizes the performance and profitability of a business. It calculates final profit after tax by tallying revenuesRevenuesRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions., expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital., gains, and losses. This document is prepared to discover areas where expenses can be controlled and more income can be generated. Thus, this data is crucial for strategizing.
No one wants to work for an enterprise that is constantly losing money; managers and executives decide to switch companies based on income statements. Similarly, lenders and banks keep a close eye on financial records to avoid loan defaults and losses.
This type of financing has its own limitations. Since these records are prepared internally, there are chances of manipulation and forgery. Further, the option of switching from one accounting policyAccounting PolicyAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level. to another provides an opportunity for manipulators. This document fails to include cash in hand. In doing so, it fails to show the ground reality. In other words, this financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. fails to represent the actual liquidity of a company.
Video Explanation of Income Statement
Finding the net incomeNet IncomeNet Income formula is calculated by deducting direct and indirect expenses from the total revenue of a business.. It is the most important number for the Company, analysts, investors, and shareholders of the Company as it measures the profit earned by the Company over a period of time. is the purpose of drafting this report. The income statement formula is as follows:
This statement records revenues, expenses, gains, and losses according to this standard format.
|(A) Net Sales||–|
|(B) Cost of Goods Sold||(-)|
|(C) Gross Profit (A-B)||–|
|(D) Operating Expenses (Salary, rent, commission insurance, etc.)||(-)|
|(E) Net Income from Operations (C-D)||–|
|(F) Other Income (Commission, interest received, rent received, etc.)||–|
|(G) Other Expenses||(-)|
|(H) Earnings Before Income Tax (E+F-G)||–|
|(I) Income Tax||(-)|
|(J) Net Profit / Net Income (H-I)||–|
Structure – Components of an Income Statement
The format focuses on the following metrics.
- Net Sales: It is the sum of a company’s gross salesGross SalesGross Sales, also called Top-Line Sales of a Company, refers to the total sales amount earned over a given period, excluding returns, allowances, rebates, & any other discount. minus its returns, allowances, and discounts. This is the starting point for every income report.
- Cost of Goods Sold: The cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. is the amount paid for the sold merchandise or the cost of manufacturing. It is computed by deducting closing stock from the aggregate value of the opening stock, net purchases, and freight charges paid.
- Gross Profit: Gross ProfitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services. is what we get after subtracting the cost of goods sold from net sales. This is before subtracting interests, overheads, taxes, and payrollPayrollPayroll refers to the overall compensation payable by any organization to its employees on a certain date for a specific period of services they have provided in the entity. This total net pay comprises salary, wages, bonus, commission, deduction, perquisites, and other benefits..
- Operating Expenses: This section comprises administrative expenses in a particular accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.. It includes rent, salary, electricity, insurance, conveyance, and commission. Planning costs ahead is crucial for businesses, as this is one area that drains profits.
- Net Income from Operations: The net operating incomeNet Operating IncomeNet Operating Income (NOI) is a measure of profitability representing the amount earned from its core operations by deducting operating expenses from operating revenue. It excludes non-operating costs such as loss on sale of a capital asset, interest, tax expenses. is the difference between gross marginGross MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold. and operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.. It represents the income from a company’s regular or main business.
- Other Income: The company can generate revenues from other sources as well. This includes rent, commission, and interest. All this cash inflow gets added to net income from operations.
- Other Expenses: Firms incur other non-operating expensesNon-operating ExpensesNon operating expenses are those payments which have no relation with the principal business activities. These are the non-recurring items that appear in the company's income statement, along with the regular business expenses. such as interest paid on borrowings and depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. . These are subtracted from net operating income.
- Earnings Before Income Tax (EBIT): Other income is added to net operating income, and other expenses are subtracted. EBITEBITEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital. is considered the company’s future earnings indicator and hence closely monitored by financial analysts.
- Income Tax: Tax payable is deducted from the EBIT to acquire net income.
- Net Profit: In order to determine net income or profit after taxProfit After TaxProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business. (PAT), operating expenses are deducted from the gross margin, then other revenues are added to it, subsequently costs and income tax is deducted. It is called the bottom line of the income statement as it represents the final result of the business activities.
Sample Income Statement
Now that we have gone through the format and structure of the income statement let us see some examples to understand its application. ABC Inc. is a hypothetical institution operating in New York. This is their financial statement for the financial year 2020-21:
(Year ends March 31, 2021)
|Particulars||Amount ($)||Amount ($)|
|(-) Sales Return||(4100)|
|(-) Sales Discount||(48750)|
|(A) Net Sales||922150||922150|
|+ Net Cost of Purchased Goods||360000|
|(-) Purchase Return and Allowance||(20000)|
|(-) Purchase Discount||(17000)|
|+ Freight Inward||1500|
|(-) Closing Stock||(235000)|
|(B) Cost of Goods Sold||500500||(500500)|
|(C) Gross Profit (A-B)||421650|
|(D) Operating Expenses||134100||(134100)|
|(E) Net Income from Operations (C-D)||287550|
|Interest Received on Investments||144000|
|Rent Received on Sub-letting Premises||7200|
|(F) Other Income||151200||151200|
|Interest Paid on Loan||126000|
|(G) Other Expenses||126000||(126000)|
|(H) Earnings Before Income Tax (E+F-G)||312750|
|(I) Income Tax (21%)||(65677.5)|
|(J) Net Profit / Net Income (H-I)||247072.5|
Thus, we can say that ABC Inc. generated $247072.5 in profits after tax for the financial year 2020-21.
How to Read Income Statement?
Given below is an example of Colgate-Palmolive company.
- First, the statement shows you how much revenue a company has earned over the years. Revenue represents total sales over the period (Total Sales = Units * Price per Unit). Therefore, Colgate’s Revenue for 2015 was $16,034 million.
- The statement format shows “costs and expenses” incurred during the year. These costs can directly or indirectly affect the revenue of the company. For 2015, Colgate’s Cost of Sales was $6,635 million.
- Revenue and costs are compared. The financial statement provides a comparative analysis of what matters. The statement shows net profit earned, if any, or net loss. In 2015, the net income for Colgate was $1,384 million.
- The structure of the statement also includes Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. (EPS) of the company. The calculation determines the price of each share, assuming all net earnings are distributed among shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.. Practically though, a firm never distributes all its earnings. Significant portions are reinvestedReinvestedReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio. into the company. This is called “plowing back of profits. Colgate’s basic earnings per share were $1.53.
- According to the Securities and Exchange Commission (SEC), these statements are “a set of stairs.” The idea is to look at the revenue and cost one by one. First, we look at the revenue, then the costs. Costs, directly and indirectly, affect sales. And then, one takes the stairs to account for interest and taxes. Ultimately, we are left with net profits or losses.
- Net profit or net loss is called “the bottom line.” It represents how much a company earned and lost during an accounting period. As a convention, investors start from the top and make their way to the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. (the net profit or net loss).
Frequently Asked Questions (FAQs)
It is a financial record that a business maintains. The firms enter, track and analyze their revenues, expenses, gains, and losses. The final output is the firm’s profit after tax for the given accounting period.
Following are the basic steps:
1. Ascertain the reporting period, whether it’s monthly, quarterly, or annually.
2. Get the relevant final figures of various expenses, stock, income, etc., from the Trial Balance.
3. Evaluate net revenue, cost of goods sold, and gross profit by putting these values in the standard format.
4. Figure out the net income from operations by deducting all operating expenses from gross margin.
5. Now, subtract the other expenses and add other income to this net operating income to get the EBIT.
6. Finally, deduct the income tax from the EBIT to acquire profit after tax.
Both are the same since both provide figures of a company’s profit or loss in a given accounting period.
This article has been a guide to an Income Statement and its Definition. Here we explain how to read the income statement along with its sample and structures. You may learn more about accounting from the following articles –