What is the Income Statement?
The income statement is one of four financial statements issued by a company every quarter and year, and covers a time period.
The purpose of the income statement is to show a company’s sales, expenses, taxes paid, and the net resulting income for the reporting period.
Structure of the Income Statement
The income statement contains four sections, resulting in (1) gross profit, (2) operating profit, (3) income before tax, and (4) net income.
Section 1: Revenue, COGS, and Gross Profit
The first section of the income statement summarizes revenue, cost of goods sold (COGS), and gross profit.
Revenue
The first item on an income statement is revenue. It is the sum of all sales recognized during a reporting period.
Cost of Goods Sold (COGS)
Cost of goods sold (COGS), also called cost of revenue, is a production expense and summarizes the cost of materials and labor used to produce the goods and services that were sold and resulted in the revenues.
Law requires companies to disclose the way COGS is calculated, and this is something that should be investigated by investors (by reading the annual reports), as this gives insight into a management’s way of thinking about reporting expenses.
Gross Profit
Subtracting the COGS from the revenue results in the company’s gross profit.
From gross profit, we can calculate the gross margin, a useful metric to assess a company’s cost management.
A company with a higher gross margin than competitors might have a competitive cost advantage.
Section 2: Operating Expenses and Operating Profit
The second section of the income statement lists the different operating expenses, including selling, general and administrative (SG&A), research and development (R&D) and depreciation and amortization, and other operating expenses.
Subtracting the operating expenses from the gross profit results in the company’s operating profit.
Selling, General and Administrative (SG&A)
Selling expenses include any advertising costs, labor costs that are not attributed to creating the products/offering services (part of COGS), rent and taxes related to selling.
General expenses are expenses related to operating the company.
Administrative expenses include executive salaries, general administrative support and taxes related to administration of the business.
Research and Development (R&D)
Continuous R&D is necessary for most businesses to innovate and stay competitive, introduce new products and services, and break into new market segments.
The percentage of sales spent on R&D ranges from low (e.g. stable companies) to high (e.g. technology-heavy, pharmaceutical companies).
A firm with a durable competitive advantage and low R&D costs is much more favorable for investors than a R&D-heavy company, since the money saved can be invested in ways that will benefit the shareholders and the long term growth of the company.
Depreciation and Amortization
Depreciation & amortization are asset write-offs over the assets’ useful life times.
Depreciation are write-offs is for tangible, fixed assets (e.g. a fleet of trucks, or analytical instruments).
Amortization are write-offs for intangible assets (e.g. patents, trademarks, goodwill).
Other Operating Expenses
Other operating expenses include any operating expenses that don’t fall in one of the categories mentioned above, and could include expenses such as operating leases or IT.
Operating Profit (EBIT)
After subtracting all operating expenses from the gross profit, we end up with the operating profit, also called earnings before interest and taxes, EBIT.
Operating profit shows us how much money is left over before interest and taxes have to be paid, and is used to calculate Times Interest Earned, a solvency ratio.
Section 3: Non-Operating Activities and Income Before Tax
The third section lists any items that are not related to the daily operations of the company.
Interest Expense
Interest expense is a financial expense that reflects the interest amount paid on the debt carried on the balance sheet.
Gain (Loss) on Sale of Assets
Gain (loss) on sale of assets lists the profit or loss from selling an asset. Since this profit or loss is not due to operating expenses, it is listed in the non-operating activities section of the income statement.
Let’s assume a company is selling a machine that it originally paid $1,000,000 for, and at the point of the sale, the machine is still worth $400,000 according to the balance sheet. If the company sells the machine for $500,000, it would record the difference of $100,000 as a gain on the income statement. Alternatively, if the company sold the machine for only $300,000, it would record a loss of $100,000 on the income statement.
A sale of an asset is a non-recurring event and should therefore be removed from the calculation of net earnings when trying to figure out whether a company has a competitive advantage.
Other
Other sums up any non-recurring, non-operating items such as the sale of fixed assets like property, plant and equipment. Another example would be the sale of a patent.
Section 4: Income Taxes and Net Income
The fourth section lists the income tax expense and the resulting net income.
Income Taxes Paid
Income taxes paid is an estimate of the income tax to be paid by the company. At the point of publishing the financial statements, the exact income tax for the reporting period is not yet known to the company, so it reports a provision based on estimates.
Net Income
Net income, also called net earnings, is the very last line on the income statement, and it reflects the amount of revenue left over after subtracting all expenses and income tax.
Since it is the last line of the income statement, net income is also referred to as the bottom line.
Net income, expressed as earnings per share (EPS), is the main number Wall Street analysts are focussed on when companies report their financial results. This is because the earnings and share price performance show a strong correlation over the long term.