What is an Income Statement?

Here is an easy to follow description that answers the question: What is an Income Statement?

An Income Statement, also called a Profit and Loss Statement, is pivotal among financial statements. It's a report card of how well management sells, controls cost, and makes a profit.

An Income Statement can be broken down into three main components:

• Revenue — the amount of money that came in the door during the period under consideration.

• Expenses — how much it cost the company to generate that revenue.

• Net Income (Profit/Loss) — the difference between revenue and expenses.

A Deep Dive into the Components of the Income Statement

Let's look at each line item on an Income Statement and understand what it means. We'll use our Smart Widgets Inc. Income Statement as an example as we go along.

REVENUE

Total Revenue: Revenue, also known as sales or turnover, is the amount of money that came in the door during the period under consideration (year or quarter). This money comes from all the sales the company made during that period.

Revenue is different from profit. We'll cover profit in more detail below. Revenue is the money that the company made before accounting for expenses the company incurred.

EXPENSES

• Cost of Revenue

  This is also called Cost of Goods Sold. If the company manufactured it's own goods, this is the cost of material and labor. If the company is reselling goods, then this is the purchase cost. If the company provides services, then Cost of Revenue includes distribution costs, product development costs and cost of providing after sales service.

  Thus, any cost that is directly related to the production and distribution of goods or services can be included under Cost of Revenue or Cost of Goods Sold.

• Gross Profit: Subtracting the Cost of Revenue out of the Total Revenue gives us Gross Profit. The only use of Gross Profit is in the calculation of Gross Profit Margin: Gross Profit/Total Revenue. A higher Gross Profit Margin is a good sign.

• Operating Expenses

  These are the expenses associated with the actual operation of the company. They include:

  • Selling/General/Admin. Expenses — these include management salaries, commissions, all payroll costs, marketing and advertising expenses, legal fees, office supplies, telephone and internet costs, etc.
  • Research & Development — this is the money a company spends on research and product development. Pharmaceutical, high-tech, automobile companies, etc. have higher R&D costs than retail companies or restaurants.
  • Depreciation/Amortization — depreciation is a charge taken to account for wear and tear of equipment over time. It's not a cash expense, but it's done for accounting purposes. Depreciation is taken over the expected lifetime of the equipment and not all at one time. Amortization is identical to depreciation, except it is applied to intangible assets like goodwill, for example.

• Operating Profit — Gross Profit less Operating Expenses gives us Operating Profit. From this we can calculate the Operating Profit Margin: Operating Profit/Total Revenue. Again, higher is better.
• Interest Income(Expense), Net Non-Operating — this covers the interest a company pays out on its debt. This is a financial charge ... it's not tied to the product or operation in any way.
• Gain (Loss) on Sale of Assets — the difference between the sale price of any asset the company sells and it's value on the company's books is recorded as either a gain or a loss. Note that sale of inventory is not included here.
• Other, Net — a catch-all for gains or losses realized by the sale of one-time, unusual items. A patent sale could be one example.
• Income Before Tax — Operating Profit less (or more) any Interest Expense (Income), Loss (Gain) on Sale of Assets, and any Other Expense (Income) yields Income or Profit before Tax.
• Income Taxes Paid — this is the income tax paid to the government ... currently around 35%. How do you check to make sure that the company is reporting its Income Before Tax accurately> One way is to check the income tax it actually pays (found by looking up the company's SEC filings). Compare that number with 65% of the Income Before Tax reported on the Income Statement. The two should match pretty closely.

NET INCOME

Income before tax less Income Taxes Paid gives us Net Income. This is often called the "bottom line" of the company and is one of the primary indicators of a company's performance.

Net Income helps us calculate the Net Margin: Net Income/Total Revenue.

Net Income gives us another important metric — Earnings Per Share...

Earnings Per Share

Net Income divided by the number of outstanding shares gives us Earning Per Share — one of the most popular and widely reported metrics in the financial community.

To figure out the number of outstanding shares, we look at the Diluted Weighted Average Shares. The number of shares of common stock at the beginning of a period, adjusted for shares canceled, bought back, or issued during the period, multiplied by a time-weighting factor, gives us Diluted Weighted Average Shares.

In summary, the Income Statement is one of the most relevant financial statements that gives us a picture of how much money the company is actually making. We've gone through every line item in detail to understand what this report is telling us and can comfortably answer the question: What is an Income Statement?

As with the other financial statements, you will get better in interpreting the financials of the company when you practice reading more and more of these statements. Use the guide here whenever you have difficulty understanding any of the line items.

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