To understand where a company is going, you have to understand where it came from and how it's operating today. If someone needs to determine the profitability and growth potential of a business, the first place to begin is with its financial documents. Perhaps one of the most important of those documents, an income statement shows all of a company’s revenues and expenses and is a key indicator of how they'll perform in the future.1
Together, we’ll dive into the mechanics and format of an income statement so you can use its information to your advantage.
Income Statement Basics
There are three types of financial statements on which analysts, accountants, CFOs, and potential investors or lenders will rely. One is the company’s balance sheet. The second is the cash flow statement. The third key financial document is the income statement, which shows the company’s revenues and expenses over a monthly, quarterly, or annual period.1
An income statement is also known as a statement of earnings, a statement of operations, a revenue statement, or a profit and loss statement (P&L), and is used by financial professionals.1,2 From a company’s income statement, you can clearly see their sales and other revenue, costs, gross profit, administrative and sales expenditures, estimated taxes, net profit, and other income and expenses.1 All of this is essential information for the company’s financial officer and executive team, founders of a startup, a private investor thinking about putting money into a business venture, or a lender who must decide whether to approve a loan application.
Luckily for those who aren’t as mathematically inclined, these figures are arranged in a clean, logical way so that the business’s profitability and growth potential can be easily assessed, sometimes even at a cursory glance. An income statement also plainly shows where improvements can be made, such as reducing the cost of sales or daily operating costs.1
Who Uses an Income Statement?
An income statement is invaluable in accounting, corporate finance, and for anyone who invests. It’s also used internally so that a financial manager can forecast the company’s financial performance (known as financial modeling), inform strategies, and propose operational changes to the executive team if needed.2
Entrepreneurs thinking of starting their own business might look at the income statements of other businesses in their industry to see any potential pitfalls before they embark on their new venture.3 A small business owner, especially of a startup, will use quarterly—or even monthly—income statements to closely monitor the health of their fledgling enterprise. Having the most up-to-date information helps owners make informed, strategic decisions quickly and fix problems before they become expensive. With a highly detailed statement, it’s possible to pinpoint every business-related expense to see where to carve out savings. This is essential intelligence for a new company on a tight budget.4
The Importance of an Income Statement in Business
To have a clear and accurate record of a company’s profit and loss over periods of time is helpful for several reasons:
- Tracks Profitability – Gives the owner, shareholders, and other stakeholders knowledge of where the company stands financially.2
- Aids in Better Decision Making – Increases owner awareness of the current financial status of the business. With accurate numbers, they can make faster and smarter decisions about new expenditures.2
- Important for Tax Compliance – Provides insight into the company’s future tax liability (along with cash flow statement and balance sheet).2
- Tracks Increases in the COG (Cost of Goods) – Shows production or purchase expenses (as well as product returns) as a percentage of sales.4
Income statements are also used, in addition to balance sheets, by lenders (investors, banks, and vendors) to set credit limits when considering applications for business loans.4
The Multi-Step vs. Single-Step Format
In financial reporting, there are two income statement formats: single-step and multi-step. The difference between the two is that while the single-step statement shows the company’s pre-tax and after-tax income, the multi-step also includes gross income (after the cost of sales) and operating income (after selling, general, and administrative expenses). A multi-step income statement shows the company’s income at four key steps in their operations. It also breaks down the categories into detail so you can see exactly what contributed to profit or loss.1,3
How to Create an Income Statement
For the most comprehensive look at a company’s financial health, you should use the multi-step format for an income statement. The key elements are:
- Net Sales / Revenue: Company’s sales of goods and/or services to its customers
- Cost of Goods Sold (COGS): Cost of goods and products sold and cost of services rendered. This includes labor, materials, and manufacturing costs. Depreciation is included here, though it may be found elsewhere. For retailers and wholesalers, this is the merchandise cost for resale.
- Gross Income: Also known as gross profit or gross margin. Must be enough to cover other expenses.
- Selling, General and Administrative Expenses (SG&A): Daily operational expenses. Increasingly shown as a percentage of sales to monitor efficiency.
- Operating Income: Subtracting SG&A from Gross Income gives you the operating income: earnings from normal operations before non-operating income, taxes, interest, and special expenses. Often used by analysts to indicate profitability (rather than net income).
- Interest Expense: Costs of company’s loans. This may be a net amount and include income from investments.
- Income Before Taxes: Earnings before income tax expense. This is often a more accurate measure of profitability than reported income.
- Taxes: This is an estimate of tax liability, rather than paid taxes.
- Special Items or Unusual Expenses: May include non recurring events, discontinued operations or restructuring charges. These are usually one-time occurrences.
- Net Income (after tax): Also known as net earnings or net profit, net income is a company’s “bottom line” and the most common profitability indicator. If expenses are greater than income, it is a net loss.1
The single-step income statement formula is simply:
Net Income = (Revenues + Gains) – (Expenses + Losses) 2
The multi-step income statement formulas are:
Gross Profit = Net Sales – Cost of Goods Sold
Operating Income = Gross Profit – Operating Expense
Net Income = Operating Income + Non-Operating Items 2
How to Read an Income Statement
Income statements follow a logical path, from top to bottom. The top line is the company’s total revenue, before expenses, while the bottom line is the company’s total profit. This is why a business’s net sales or net income is known in the financial world as its bottom line.5
Whether you’re helping to improve company profits as a CFO, studying the financial decisions of successful competitors as a startup founder, or determining if a company is well positioned for future growth as an investor, being savvy with income statements gives you a distinct advantage.6
Build From the Basics for a Successful Career
Knowing how to prepare and analyze an income statement is an in-demand skill for today’s competitive business environment. To build on this foundation and explore more nuanced formulas and principles, financial and accounting professionals should consider an online Master's in Accounting degree from Yeshiva University’s Sy Syms School of Business. The dynamic and innovative program, taught by seasoned industry professionals, will give you the expertise you need to succeed.
- Retrieved on November 29, 2021, from investopedia.com/articles/04/022504.asp
- Retrieved on November 29, 2021, from deskera.com/blog/income-statement/
- Retrieved on November 29, 2021, from thestreet.com/personal-finance/education/what-is-an-income-statement-14899351
- Retrieved on November 29, 2021, from inc.com/articles/2000/05/18739.html
- Retrieved on November 29, 2021, from bench.co/blog/accounting/how-to-read-income-statement/
- Retrieved on November 29, 2021, from zoho.com/books/guides/what-is-an-income-statement.html