Income statement: Definition, Importance and Example
An income statement, also known as a profit and loss statement, is a financial statement that shows the income and expenses of a business. It also indicates whether a company makes a profit or a loss for a period under review.
Along with the balance sheet and cash flow statement, the income statement helps you understand the financial health of your business.
Income statement communicates how much revenue the business has generated over a period and what costs it incurred in relation to generating that revenue.
The Income Statement Vs. The Balance Sheet
While the definition of an income statement may look like a balance sheet, the two documents are designed for different uses. An income statement calculates income and expenses; while a balance sheet records a company's assets, liabilities and equity.
Importance Of An Income Statement
The income statement is very important to every business, irrespective of the size and location of the company. They are important in the following ways:
1. Decision making
It helps business owners decide whether they can make profit by increasing revenue, decreasing costs, or by applying both methods.
2. Evaluate business strategies
It also shows the effectiveness of the strategies that the company set itself at the start of the year. Entrepreneurs can refer to this document to see if the strategies worked out as expected or they should review it.
3. Improve productivity
Based on their analysis after reviewing their business strategies, they can come up with the best solutions on how to make more profit.
What Is The Purpose Of The Income Statement?
While the primary purpose of an income statement is to communicate details about the profitability and business activities of the company to interested parties, it also provides detailed information about the inside of the company for the purposes of comparison between different companies and different sectors.
The Following are the things that an income statement informs:
1. Frequent reports
While other financial statements like balance sheet and cashflow statement are published annually, the income statement is published quarterly or monthly depending on the company's need. Because of this, business owners and investors can closely monitor the performance of the business and make informed decisions. It also allows them to find and fix small business problems before they get big and expensive.
2. Pinpointing expenses
This statement points future expenses or any unforeseen expenses incurred by the business and any areas that are over or under budget. The expenses include the rent of the building, salaries and other overheads. When a small business begins to grow, its expenses can increase. These expenses may involve employing workers, purchasing supplies, and business promotion.
3. Overall analysis of the company
This statement provides investors an overview of the company in which they intend to invest. Banks and other financial institutions can also review this document to decide if the company is creditworthy.
Also Read: How to Prepare An Income Statement
Users Of Income Statement
Who uses an income statement? There are two main users of income statement: internal and external users.
1. Internal users
Internal users consist of the management and board of directors of a company, who use this information to scrutinize the position of the company and make necessary decisions to make profit. They can also act on any doubts related to cash flow.
2. External users
External users include investors, creditors, and competitors. Investors check whether the business is able to grow and be profitable in the future, so that they can decide whether to invest in the company. With the income statement, creditors can see if the business has enough liquidity to repay loans or take new ones. Competitors use them to gain insight into a company's success metrics and learn more about areas where the business is spending a little more.
Also Read: How to prepare a balance sheet
Components Of An Income Statement
Generally, an income statement format shows the following components
1. Revenue or sales
This is the first section and it provides a summary of the gross sales of the business. Revenue can be classified into two types: operating and non-operating revenue. Operating revenue is the income generated by a company through performing primary business activities such as producing a product or offering a service. Non-operating revenue is generated by performing secondary business activities such as installing, operating or maintaining a system.
2. Cost of goods sold (COGS)
The cost of goods sold is the sum cost of sales or services, also known as the cost incurred to produce goods or services. Take into consideration that it only includes the cost of the products you are selling. COGS generally excludes indirect costs, such as overhead.
3. Gross profit
Gross profit is calculated by subtracting net sales from the total cost of goods sold in your business. Net sales is the money you made on the goods sold, while COGS is the money you spent on producing those goods.
Gains are the result of a positive event that increases the revenue of an organization. Gains are the money a company makes from different business activities like sale of a business segment. Likewise, one-off profits from non-business activities are also included in the gains of the the business.
For Instance, a company that sells of its old vehicles or unused land, etc. Although gain is seen as a type of secondary income, the two terms are different. Income is money received by a business on a regular basis while the gain can be recognized for the sale of fixed assets, which is considered a fixed asset for the business.
Expenses are the costs that the business must incur to generate income. Some examples of frequent expenses are depreciation of equipment, staff salaries, and payments to supplier. The two main categories of business expenses are operating and non-operating expenses.
Expenses incurred by the main activities of the business are known as operating expenses, while those that are not incurred by the principal activities are called non-operating expenses. Sales commission, pension contributions, payroll account for operating expenses while examples of non operating expenses include outdated inventory charges or settlement of lawsuit.
6. Advertising expenses
Advertising expenses are the marketing costs incurred to expand the customer base or get new customers, such as advertisements in print and online media, as well as (audio-visual) radio and video advertisements. Advertising costs are typically viewed as part of selling, general and administrative (SG&A) costs.
7. Administrative expenses
Administrative expenses can be defined as expenses incurred by a business as opposed to those associated with specific departments within the same business. Some examples of administrative expenses include salaries, rent, office supplies and travel expenses. Administrative expenses are fixed and are prone to exist regardless of the level of sales.
Depreciation is the practice of spreading the cost of an asset over its life. It is a management agreement to write off the value of a company's assets, however, it is considered a non-cash transaction. Depreciation primarily shows the value of the asset used by the business over a period under review. Examples of assets that can be depreciated include: Motor van, plant and machinery, furniture and fittings, etc.
10. Earnings before tax (EBT)
It is a measure of how a company performed financial. Earnings Before Tax is ascertained by deducting expenses from income, before tax. It is one of the components of a multi-step income statement.
11. Net income
Net income can be defined as the amount of money you earn after deducting qualifying business expenses. It is calculated by subtracting total expenses from total income. While net profit is the profit of a business, gross profit can be defined as the money earned by a business after deducting the cost of goods sold.
Income Statement Analysis
There are two methods used by an companies to read and analyze financial statements, the methods are: vertical analysis and horizontal analysis. The two methods are almost similar, but the difference between them is how a statement is read and the comparisons you can make against each other.
1. Vertical Analysis
Vertical analysis is the method of financial analysis in which each item is listed as a percentage of a base figure in the report. This means that income statement items are displayed as a percentage of gross sales, rather than exact amounts of money, like dollars.
in a nutshell, it is the process of reading a single column of data in an income statement, determining how individual items relate to each other (for example, showing the relative size of different expenses, as items can be listed as a percentage of operational expenditure).
This type of analysis makes it easier to compare income statements between periods and sectors and between companies because you can see the relative proportions. It also helps you analyze whether performance metrics are improving.
Vertical analysis is not always as instantly useful as horizontal analysis, but on the long run, it can help you determine questions to ask, for example: where have costs increased or decreased? Which line items contribute the most to profit margins? How are they affected over time?
2. Horizontal Analysis
While vertical analysis focuses on each item as a percentage of a base figure during a current period, horizontal analysis examines and compares changes in dollar amounts on a company's balance sheets over multiple reporting periods. It is often used in absolute comparisons, but can also be used as a percentage.
Horizontal analysis makes financial data and reports conform to Generally Accepted Accounting Principles (GAAP). It Improves a company's consistency review over time, as well as its growth compared to its competitors.
For this reason, horizontal analysis is important for investors and analysts. By performing horizontal analysis, you can determine what has driven an organization's financial performance over the years and identify trends and growth patterns, item by item. Eventually, horizontal analysis is used to identify trends over time, such as Q1 to Q2 comparisons, instead of revealing how individual line items relate to each other.
How To Read An Income Statement
Each financial statement that you review will have a heading that includes the name of the statement, such as "Income Statement". The heading will also include your business name, e.g "Trendingaccounting Limited" and the end date of the period represented by the statement. "as at 31st April, 2020".
To understand how an income statement works, let's analyze the two income statement formats
Single-step Income Statement Example
|Single-step income statement|
Multi-step Income Statement Example
|Multi-step Income statement|
In reality, companies that operate globally provide a great variety of products and services and engage in mergers and partnerships. As a result of these activities, they have a complex list of activities and expenses to record. These companies must also comply with specific reporting regulations.
This is why large companies opt for multi-step income statements. In this system, operating income, operating expenses and profits are separated from non-operating expenses, non-operating income and losses. Profitability is represented at four levels: gross, operating, pre-tax and after-tax.
An income statement is a rich source of information on the key factors responsible for the profitability of a company. It provides timely updates because it is frequently generated than any other statements.
It indicates the expenses, income, gains and losses of a business, which can be used to arrive at the net profit or loss for that time. This information helps you make prompt decisions to ensure that your business is in good financial health.