What Is An Income Statement?
The income statement is one of the main financial statements that companies prepare regularly to measure their financial health. The income statement—also known as a profit and loss statement (P&L)—shows the company's profitability over a given period of time. Most public companies prepare income statements quarterly, and private companies may do it more frequently, such as monthly.
Investors use income statements to discern the basic profitability of a company, meaning the difference between revenue and expenses. They generally come with side-by-side comparisons to a previous period, usually the prior quarter and the same quarter from the previous year.
Companies also usually provide annual income statements with comparisons to previous years, often going back as far as 5 or 10 years. As a result, the income statement shows whether the company's revenue and expenses are rising or falling and how that affects profitability.
Sections Of An Income Statement
The income statement is divided into several sections.
The top section lists revenue. Depending on the type of company, this would include all sources of income, including sales revenue, interest income and other revenue. Companies vary on the level of detail they show in the revenue section, and a more detailed description is usually found elsewhere in the company's financial reports.
The next section shows expenses. Depending on the company, employee expenses, such as wages and benefits, are usually the biggest cost. Other common types of expenses include the cost of goods sold, which is the total cost of making the company's products or providing its services. There are also sales expenses, advertising and marketing, research and development, interest expense on debt, buildings and rent, depreciation and the like.
Gross And Net Income
The difference between revenue and expenses is called gross, operating, or pre-tax, income.
Finally, the company subtracts corporate income taxes from operating income to arrive at its net income, also called net profit or net earnings.
Why Should I Know About Income Statements?
Income statements are useful not only in showing how profitable a company is, but also the company's operating performance from one period to the next, taking both revenue and expenses into consideration. Profits may increase for several reasons, but not all of them may be positive. Likewise, a drop in earnings may be due to a positive development and therefore only a temporary setback.
As a result, investors need to look beyond the "bottom line," or net income, and look at the direction of both sales and expenses.
For example, profits may be increasing even though sales revenue is declining. That could be the result of the company cutting expenses, including laying off employees or closing factories and offices, due to falling sales.
Conversely, profits may not be keeping up with the rate of sales. While this may be due to increased overhead, which may be a negative sign, it could also be due to positive reasons. These can include a new product or service launch that required a large investment in factories, new hires, advertising expenses, R&D, and other costs needed to boost future sales growth.
Indeed, younger companies often run losses early in their existence as they gear up and grow. As long as sales revenue is growing or promises to, losses may be an acceptable cost of doing business, at least in the early going.
The income statement outlines a company's profitability for a specific period of time, subtracting expenses from revenue. Investors need to look beyond the bottom line, however, and examine the direction of both sales revenue and expenses. Rising profits amid falling sales may indicate that the company is cutting back in some areas, while declining earnings with higher sales may indicate that the company is investing in its future.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…