The income statement is one of the key financial documents (along with the balance sheet and the statement of cash flow) used to assess a company's financial performance. It is frequently called the profit and loss statement, which explains precisely what it is intended to show: how much money a company made (or lost) over a given time period, usually a quarter or a year.
As the above definition suggests, the income statement is a simple arithmetic expression of revenues minus expenses. Revenues may come from sales of the company's products or services or from the sale of assets. Expenses and losses reflect what it cost to produce the company's product or service or any losses incurred from selling off assets, lawsuits, etc. Net income or loss is the balance. This is, literally, "the bottom line."
Understanding the terminology
Conceptually, the income statement is very straightforward, but it does use specific terminology that needs to be clarified. Start with gross revenue, the total amount of revenue derived from sales of products or services. Subtract the cost of sales or cost of goods sold (COGS), expenses directly related to producing the company's product or service (e.g., raw materials or the labor involved). What is left is the company's net revenue.
At this point, one subtracts expenses not directly related to the production of goods or services, usually referred to as general and administrative (G&A) expenses, such as rent, salaries of administrative staff, marketing, and sales or research. These are all part of the company's operating expenses. Once these are subtracted, along with depreciation, in effect the cost of using equipment and other assets during the given time period, one is left with operating income.
Before one can determine the actual bottom line, however, there are more items to be accounted for. Adding in any income from other sources, such as interest or sales of assets, brings us to a frequently cited number, EBIT, or earnings before interest and taxes. Once loan repayment and income taxes are subtracted, we have reached the bottom line, net income.
Generally accepted accounting principles (GAAP) and public accounting conventions
Where the income statement gets complicated is in understanding the assumptions underlying the seemingly simple line items. This is why investors are admonished to read the footnotes! The footnotes contain critical details and explanatory information about such things as income taxes, stock options, retirement programs, accounting policies, and how inventories are valued. This is also where complex issues, such as lawsuits are explained. There are some standards for footnote disclosures, but much is also left to management's discretion, which means one must read carefully.
Generally accepted accounting principles provide a consistent basis for understanding how companies account for their assets, income, etc. They comprise some standards established by different policy boards, but also many assumptions and concepts that have become standard practice. Perhaps the most important of these accounting conventions refers to different methods of accounting. The accepted standard is historical cost or accrual accounting. This method, as it affects the income statement, recognizes revenues when the sale of a product or service occurs and expenses when they are incurred.
While accrual accounting matches sales to expenses well and gives the most accurate picture of a company's financial condition, it does not reflect the dates on which revenues are actually received or expenses paid, which is why a separate statement of actual cash flow becomes so important. More than one company, especially young and growing ones, have looked like superstars on their income statements, but been forced to cease operations for lack of cash.
Frequently asked questions
What is the difference between an income statement and a statement of cash flow?
These two documents are sometimes confused because they both have to do with how much money a company is making or losing. As indicated above, the difference lies in when revenues and expenditures are incurred and when the related cash transactions actually occur. On a personal level, one might compare this to using a credit card, where the dates of purchase and payment differ, or a debit card, where purchase and payment are recorded simultaneously.
The two statements also differ in other ways. You will not see a line item for depreciation on a cash flow statement; it is not a cash transaction. Instead, the full brunt of capital expenditures is recognized when the expenditure actually occurs. The cash flow statement also separates investments and financing transactions. These differences are designed to clarify the actual amount of cash available to the company.
How does the income statement differ from the balance sheet?
While the income statement tell us about earnings and how much money a company has made or lost during a specified time period, the balance sheet tells us what the company is actually worth at one specific point in time.
What is meant by standard financial ratios?
Ratios are ways of measuring performance. In most instances, what is important is not the ratio itself, but what happens to it over time (how it trends) and/or how it compares with competitors’ ratios. The most important ratios use numbers from both the balance sheet and the income statement.
Return on assets (ROA) is a measure of profitability and asset performance. A high percentage implies good performance. It is expressed as:
ROA = Earnings before interest & taxes (EBIT) / Total assets
Return on equity (ROE) is also a measure of profitability, but the focus is not on asset performance, but rather on how well a company is doing for the amount of equity invested in it. It has particular value in comparing competitors. The formula is:
ROE = Net income / Common equity
Earnings per share, or EPS, is an expression of shareholder value, telling how much one share of a company would be worth if the earnings for that period were evenly divided. It is computed using the following formula:
EPS = (Net income – Dividends on preferred stock) / Average number of outstanding shares