Income Statement: What You Need To Know
The income statement tells a story about your business’s performance.
It tells you how much revenue your business generated, the money spent to generate that revenue, and total earnings.
In this guide, I’m going to go over the purpose of an income statement and show you how to get valuable business insights from it.
What is an Income Statement?
An income statement is a financial statement that shows your company’s financial performance from a profitability standpoint. It focuses on:
- Your business’s revenue,
- Money you’ve spent to make that revenue, and
- Various types of profit.
Before we dive deeper into these elements, let’s quickly talk about how an income statement differs from a balance sheet.
Income Statement vs Balance Sheet
Here are the two main points of difference between an income statement and a balance sheet:
| Income statement | Balance sheet | |
| Time period | The income statement tells a story about your business’s performance over a specific period — usually a month, quarter, or year. | A balance sheet show you a snapshot of your financial position on a specific day. |
| Content | An income statement includes transactions related to revenue and expenses. | A balance sheet is a summary of all accounts that have either a debit or credit balance. These accounts are categorized as assets, liabilities, and shareholders’ equity. |
Elements of an Income Statement
All line items in an income statement belong to one of three categories:
Let’s talk about each category.
Revenue and Gains
Revenue and gains are viewed as positive elements—you want them to be as high as possible because they’re directly proportional to net income. Here are the different types of revenue:
Operating Revenue
Operating revenue is revenue generated from business activities. If you’re a B2B SaaS company, money generated from subscriptions would be considered your operating revenue. If you’re an ecommerce store selling fitness products, revenue from the sale of supplements, equipment, and activewear is your operating revenue.
Non-Operating Incomes and Gains
Non-operating income or gain includes the profit from non-operating activities—aka things that make you money, but are not the intention of your business.
For example, if your business sells a property or office furniture for more than it bought it for—known in accounting-speak as its “book value”—the gain would add to your total non-operating income.
Expenses and Losses
Expenses are money spent to run the business, while losses are incurred when you sell an asset for a price lower than its book value. Here’s a bit more information on each:
Operating Expenses
Operating expenses are incurred to support core business activities. Rent, marketing, and salaries are examples of operating expenses.
Non-Operating Expenses and Losses
Non-operating expenses include inventory write-offs, lawsuit costs, and money paid on interest. It’s considered a loss when you sell an asset below its book value or record the impairment of an intangible asset.
Profits
When you add up the revenues and subtract all expenses, you’re left with a profit or loss. However, you’ll see various types of profits (or losses) on your income statement, and all of them offer valuable insights.
Gross Profit
Gross profit shows the profit you’re making on just the core product or service. It’s calculated as:
Gross Profit = Sales Revenue - Cost of Goods Sold OR Cost of Sales
Dividing gross profit by revenue gives you the net margin. While there’s no one-size-fits-all number, each industry has an average gross margin. If your gross margin is above average, that’s a good sign.
Operating Profit
Operating income is the amount of profit calculated by subtracting operating expenses like sales, general, and administrative expenses (SG&A) from gross profit.
You may have heard about EBITDA and EBIT. They are often used interchangeably with operating income. However, operating income, EBITDA, and EBIT are technically different numbers.
These numbers don’t appear on an income statement because they’re not Generally Accepted Accounting Principles (GAAP) metrics. They’re calculated separately for financial analysis. Here’s how:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
EBIT = Net Income + Taxes + Interest
Note: In a multi-step income statement, all the non-operating items (both gains and losses) appear after operating income.
Net Profit
Net profit, also known as net income, is the amount of profit that remains after accounting for all expenses, including taxes. This profit is available to use at the discretion of the company’s operators and shareholders. For example, the company may pay shareholders a dividend or retain profits to support growth.
Net income is also used to calculate earnings per share (EPS) in companies that don’t have preferred stock. Companies with preferred stock must first remove preferred stock dividends from net income to calculate EPS.
EPS = Net Income / Weighted Average Number of Common Stock Outstanding
Extraordinary Items
A gain or loss is informally considered “extraordinary” whenever the amount is above the materiality threshold. However, a gain or loss is only classified as extraordinary if it’s:
- Abnormal, i.e., it’s not generated from ordinary business operations
- Infrequent
- Unlikely to recur in the foreseeable future
Think of a person who sells popsicles: When a flood destroys the seller’s cart, they’ll record it as an extraordinary loss. However, he can’t report this loss as an extraordinary item if the seller lives in a region where floods are common, because floods are an inherent operational risk.
Extraordinary items are more relevant for large companies’ financial reporting. Analysts usually exclude extraordinary items for analysis because it’s a one-off event.
How to Structure an Income Statement
When preparing an income statement, the structure varies based on whether you’re preparing a single-step or multi-step income statement.
A single-step income statement condenses revenues and gains into one category and expenses and losses into another.
Total expenses and losses are subtracted from total revenues and gains to calculate the net income—there’s no gross profit or operating income on a single-step income statement.
Here’s an example:
| Revenues and Gains | |
| Sales | $100,000 |
| Interest income | 10,000 |
| Total Revenues and Gains | 110,000 |
| Expenses and Losses | |
| Cost of goods sold | 60,000 |
| Office supplies | 5,000 |
| Interest | 10,000 |
| Loss from lawsuit | 15,000 |
| Total Expenses and Losses | 90,000 |
| Net Income | $20,000 |
However, a multi-step income statement is more common.
In a multi-state income statement, operating and non-operating revenues and expenses are presented separately, like this:
| Sales | $100,000 |
| Cost of goods sold | 60,000 |
| Gross Profit | 40,000 |
| Operating Expenses | |
| Office supplies | 5,000 |
| Interest | 10,000 |
| Operating Profit | 25,000 |
| Non-Operating Items | |
| Interest income | 10,000 |
| Loss from lawsuit | (15,000) |
| Net Income | $20,000 |
If this looks completely alien to you, just focus on understanding the elements within it; accounting software can automatically prepare the statements.
How to Analyze an Income Statement
The income statement is an excellent performance assessment tool and a vital component of the three-statement model used for financial analysis. Each element tells you something about your business’s performance. Here’s how to analyze the elements of an income statement:
Revenue
Operating revenue is an excellent way to assess growth. Compare the company’s revenue across time periods to assess revenue growth. Look for a prevailing trend—is revenue growing steadily or fluctuating? Is the trend upward or downward? Are there short-term fluctuations?
When analyzing revenue, keep in mind that:
- You might see effects of seasonality or cyclicality in the revenues of companies that sell products like steel or real estate.
- Checking revenue concentration among customers, products, or geographic regions can help you gauge a company’s concentration risk. If 50% of a company’s revenue comes from one client, that’s a red flag.
- Revenue recognition practices may impact a company’s revenues based on factors like internal policy, accounting standards (ASC 606 and IFRS 15), and industry-specific rules or conventions.
Cost of Goods Sold
Start by looking at the cost of goods sold (COGS). COGS includes all direct costs, including raw materials, labor, and overheads. When COGS is higher than revenue, your gross margin turns negative.
Companies with a negative gross margin have little chance of long-term survival unless they increase prices, reduce direct costs, or otherwise become more efficient at, well, making money.
Operating Income
Analyze how much your business spends on operational expenses. High operational expenses translate to low operating income. Companies with low operating margins may find it difficult to grow at a decent pace.
For example, if you expect business to be slow for the foreseeable future, consider downsizing your office space to save on rent or skip the annual office trip.
Net Income
No amount of revenue growth or operating income is good if it doesn’t trickle down to net income. If you have a net loss, despite positive operating income, analyze non-operating expenses and see where there’s room to make cuts.
If your net income shot up significantly without a major change in revenues, there could be a one-time or extraordinary gain on the income statement. You should exclude the impact of this gain during your analysis — sustainable earnings growth typically comes from consistent performance core operations, not one-off events.
The Role of the Income Statement in Financial Reporting
The income statement has various roles in financial reporting, such as complying with financial regulations, helping stakeholders make financial decisions based on performance, and enabling investors to compare the company’s performance with competing businesses.
For simplicity’s sake, let’s boil down the role of an income statement into two important use cases:
- Shows business performance: The income statement shows how well (or poorly) your business did in terms of profitability over a certain period. It helps you compare performance over time and with competing businesses. You can use the income statement to understand your cost structure and identify potential areas for cost reduction in cases of poor performance.
- Helps calculate net income: When businesses generate revenue and earn income, they gain value. The value must flow from the income statement to its rightful owners — equity shareholders — after accounting for any preferred stock dividends involved. The net income figure is transferred to the statement of shareholders’ equity. Entries for preferred and common stock dividends appear here. The remaining amount (retained earnings) is transferred to the equity shareholders' account, which appears on the balance sheet.
Income Statement: A Time-Bound Story of Your Business
If there’s one message I want to leave you with, it’s this: Think of the income statement as the story of your business over the past year. It tells you how much your business sold, how much it spent to operate, and how much you earned from it during a given period.
However, it’s important to remember that even profitable businesses can fail if they run out of cash. Net income is not equal to cash generated, as I explain in the cash flow statement guide.
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