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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Income Statement

What is an Income Statement?

The income statement is one of the three primary financial statements used to assess a company’s performance and financial position (the two others being the balance sheet and the cash flow statement). The income statement summarizes the revenues and expenses generated by the company over the entire reporting period.

The income statement is also known as a profit and loss (P&L) statement, statement of earningsstatement of operations or statement of income

Income Statement Example

The basic formula on which an income statement is based is:

Revenues – Expenses = Net Income

All companies need to generate revenue to stay in business. Revenues are used to pay expenses, interest payments on debt and taxes owed to the government. After the costs of doing business are paid, the amount left over is called net income. Net income is theoretically available to shareholders, though instead of paying out dividends, the firm's management often chooses to retain earnings for future investment in the business.

Income statements are organized similarly no matter what company is being analyzed, but some line items may differ depending on the industry. The basic outline is shown in the following example:

Company XYZ's Annual Income Statement
  
Revenue$2,000,000
Operating Expenses: 
Salaries($1,000,000)
Rent($500,000)
Amortization($25,000)
Depreciation($75,000)
Operating Income$400,000
Interest Expense($50,000)
Tax($100,000)
Net Income$250,000

Anyone interested in active investing, picking stocks or investigating the financial health of a company must know how to read financial statements, including the income statement. The importance of the information contained in the income statement cannot be overemphasized.

A firm's ability or inability to generate earnings over the long term is the key driver of stock and bond prices. Operating profit (EBIT) is the source of debt repayment, and if a company can't generate enough EBIT to pay its debt obligations, it will have to enter bankruptcy or sell itself.

Net income is the source of compensation to shareholders (owners of the company), and if a company cannot generate enough profit to compensate owners for the risks they've taken, the value of the owners' shares will plummet. Conversely, if a company is healthy and growing, higher stock and bond prices will reflect the increased availability of profits.

Please note that earnings/net income/profits are not the same as cash or cash flow. It is possible for a firm to be profitable on the income statement, but not be generating cash flow, and vice versa. To see a company's cash flow, you will need to examine its statement of cash flows.

[Recommended reading: Financial Statement Analysis For Beginners]

Multi-Step Income Statement

A multi-step income statement, also called a multi-step profit and loss statement, lists and separates a company's operating revenues/expenses from its non-operating revenues/expenses, gains, and miscellaneous income and cost items. 

The operating revenues and operating expenses represent a business' income and costs that are directly involved in operations -- such as income from a sale or service, and expenses related to salaries, rent, and supplies, among other things. At the top of the operating income section, a company lists its revenue, which is sometimes followed by its costs of goods sold/cost of revenue. The difference of these two items results in a company's gross profit.

Non-operating revenue is considered business income that does not play a part in the company's main business function, and may include interest income, investment income, or property gains. Non-operating expenses also do not relate to a company's day-to-day business function, and may include interest expense on outstanding loans, income taxes, investment losses, or legal fees/legal settlement costs.

Common Size Income Statement

A common-size income statement is an income statement in which each line item is expressed as a percentage of sales. 

For example, the top line of a common-sized income statement might say $100,000 in sales, which would equal 100% of sales (shown on the right side of the income statement). If operating expenses amounted to $50,000, that would equal 50% of sales.

The common-sized income statement allows for easy comparison. Not only can it show readers how much of every dollar goes to each expense (rent, for example), it also lets them compare how much a company spends compared to another company on an apples-to-apples percentage basis.

[Make stock comparisons easier -- see How to Common Size Financial Statements]

Single-Step Income Statement

A single-step income statement is a simplified income statement that combines operating and non-operating income and expenses.

The formula for a single-step income statement is stated as:

(Revenues + Gains) - (Expenses + Losses) = Net Income

Comparing the Balance Sheet Vs the Income Statement

An income statement shows how well a company did financially over a period of time (typically over a year or quarter). It shows how much income the business brought in, how much it spent, and (most importantly) how much it generated in profit over that period.

A balance sheet can be seen more as a "snap shot" of a company's financial health on a select date, rather than over a period of time. The balance sheet shows how much a company's assets are worth (including cash, inventory, buildings, investments, and accounts receivables) on a given date. It also shows how much the company owes to non-shareholders (liabilities such as debt, accounts payable, taxes owed) and how much of it is owned by shareholders. 

Investors and financial analysts study both the income statement and balance sheet of a business to get a complete picture of its financial health. Using elements of both the income statement and the balance sheet, analysts may also use financial ratios to see if a stock is undervalued or overvalued, measure how profitable a company is based on its assets or equity levels, or to assess how capable a business is of meeting its debt obligations.

[How healthy is that company and its stock? See the 15 Financial Ratios Every Investor Should Use]
 

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