Career Testing
Career Testing
Career Testing
CAREER ADVANCEMENT / JUN. 28, 2014
version 2, draft 2

How to Understand an Income Statement

An income statement is an important financial document, both for yourself, and for a large company, business, or corporation. As an individual, you’ll likely receive one every month, as well as one at the end of the tax year (these documents go by a variety of names depending on your specific country). It will indicate how much you made, and list any and all deductions taken off. A business income statement is essentially the same thing, listing both the income (or revenue, or sales) and expenses (operating costs) over either a fiscal quarter (3 month period) or year. As an individual, your income statement is your means to keep track of everything you made - minus all deductions - for tax purposes. For a company, it’s an invaluable document for investors (or business owner) to gauge the financial health of the business.

Understanding an Income Statement

It’s actually straightforward. Depending on the number of industry jargon and acronyms used, everyone should be able to understand a basic income statement. At the very top, you’ll see the name of the company (or individual), and a date (along the lines of “for the period of” or “for the period ending”).

The Bottom Line

Ever hear that expression? It refers to an income statement, where the literal bottom line indicates how much actual profit has been made. The deductions, and costs, and everything else have already been removed and factored into the calculation. If you only want to know how much money a business has made, you only need look at the bottom line.

An Inverted Pyramid

Think of an income statement (also called a statement of income or earnings) as an upside-down pyramid. It’s (hopefully) very large at the top, getting progressively smaller as you move towards the bottom, taking off various deductions and related costs. You end up at the considerably smaller bottom point...the actual profit made.

So, starting at the top and working down, you’ll typically see…

  • Gross Income (aka Gross Revenue, or Gross Earnings, or Sales Revenue) - this is the largest number you’ll see on the statement. It’s the figure for how much money was earned via the sale of the goods or services provided by the company. It does NOT go into specific details. It simply indicates the total sum.
  • Operating Costs (sometimes specifically Cost of Goods Sold, or Cost of Sales) - the second number listed is usually the operating costs or expenses. Obviously, the amount collected in any business is not pure profit (wouldn’t it be great if it was?). This figure will specifically include the cost of production materials, labour, and production facilities. If the company sells a physical product, they have to buy the material(s) to make it, pay people to put it together, and build/maintain someplace to do so (or purchase it wholesale from someone who does all that for them). This total amount is the Cost of Goods Sold, also known as the Cost of Sales, or the much more generic Operating Cost.
  • Gross Profit (aka Gross Margin) - the gross income minus the operating costs gives you the gross profit, which is usually the third line of the statement. This is the amount leftover after deducting the cost to make the good sold. The amount is much smaller now, and sadly, we’re still not done with the deductions.
  • Selling, General, and Administrative Expenses (aka SG&A) - the fourth figure indicates other expenses related to running a business, but separate from the cost of production (or buying wholesale). The selling includes salaries of sales staff (such as retail store clerks), advertising, and store costs such as rent. General expenses include all other general costs associated with the business, while administrative expenses executive and support staff salaries. This is yet another major deduction.
  • Operating Earnings (aka Operating Profit, or Operating Income) - Gross profit minus SG&A leaves us with the operating earnings. Our pyramid continues to get smaller and smaller. This figure is considered a much better indicator of financial health than Gross Income, as it has the total operation costs already deducted (cost of sales + SG&A). A sizable amount at this stage means a profitable business.
  • Interest Expense - Time for another deduction to whittle away at our overall profit. Noticing a trend? The interest expense includes all (if any) revenue lost to interest payments on any existing loans. Ideally, the number would be zero, but as the saying goes, you need to spend money to make money. Most companies have at least some outstanding loans on their books.  
  • Earnings Before Tax (aka Pretax Income or Profit) - Operating earnings minus interest expense gets us to pretax profit. We are almost at the end, but our initial figure (gross income) is much, much smaller.
  • Income Tax Expense (aka (Estimated) Income Taxes) - this FINAL (yay!) deduction indicates the estimated amount that will be lost to income tax.
  • Net Profit (aka Net Earnings, or Net Income) - Earnings before tax minus income tax expense gives us our bottom line. The net profit line tells us exactly (or as close to exactly as can currently be calculated) how much money was made during the specified time period. Of course, it’s possible to have a negative number by this point (remember all those annoying deductions?), in which case we are left with a Net Loss.

Anything Else?

A company may have other revenue streams, such as investments, and they would be indicated on a separate line somewhere near the (wide) top of our inverted pyramid. They may also have special items (basically a one-time expense) that would appear on a separate line somewhere near the bottom of the statement.

It’s not terribly difficult. The entire calculation is straightforward, starting with the largest number possible (gross income) and systematically deducting from that amount until we are left with a much smaller number - our actual profit.

An individual income statement works the same way, starting with the largest number at the top (the gross income earned that month or year), and deducting various expenses such as tax, pension, and investment contributions, until reaching the net profit on the bottom line.

Now that you understand it, take a look at the most recent income statement for a company before you invest with them (or even just out of curiosity). Remember that Operating Earnings is a better indicator of financial health than simply looking at the gross profit...lots of money taken in, but combined with equally hefty expenses, results in very little profit. And finally, don’t let finances intimidate you. They aren’t that scary.

 

Photo courtesy of Pixabay

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