What Is an Income Statement?

What is an Income Statement thumbnail

When you open a firm’s Annual Report you will quickly find the Income Statement of an organization there.  

What exactly is an Income Statement?

In practice, this report adopts various names, such as the Statement of Operations, the Statement of Earnings, or simply the Profit and Loss Statement. Whatever the title, it all comes down to the very same thing – a company’s profit, or net income, generated as a result of the normal business operations.

What is the structure of a typical Income Statement?

The two primary drivers of net income are REVENUES and EXPENSES. In turn, Revenues minus Expenses gives us the net income figure for the period. That’s basically the final product of an Income Statement. Nevertheless, we need to consider a few other sub-totals, in order to calculate it.

Suppose you work as a financial analyst and you have been assigned to analyze the Income Statement of Milky Way Inc – a dairy company that produces and sells milk and cheese to supermarket chains (see the table below).

Milky Way Inc. Statement of Comprehensive Income

Understanding Revenue in the Income Statement

First, you look into the company’s revenue.

This is the amount reported from the sales of goods and services in the normal course of the business operations. The economic benefits Milky Way receives from selling its products to customers is known as Gross Revenue;  it is $53,488 million in the latest financial year.

Some supermarkets, however, may return products that are close to their expiry date. Others may be eligible to trade discounts. When Gross Revenue is adjusted for such estimated returns and allowances, then you get to Net Revenue. This is why the Net Revenue figure of $47,806 million differs from the Gross Revenue amount.

Oftentimes, companies generate funds outside their core operations, too. For example, a firm may rent some of its real estates or even benefit from the sales of manufacturing equipment. Any additional sources of revenue go into “Other Revenue”. If Milky Way Inc rents out one of its warehouses and receives $1,000 million in return, it writes down the pay-off there. This activity is not part of the core business of the firm. In effect, such a distinction allows us to separate core business sales from non-core activities. This presupposes meaningful comparisons between competing companies’ operating and non-operating financial results.

As you can see, the Total Revenue represents the sum of both Net Revenue and Other Revenue. It decreased slightly from $50,041 million in the previous financial year to $48,806 million in the latest accounting period.

Understanding expenses in the Income Statement

These are defined as the outflow of economic resources that occur in the normal course of business activities. To produce, deliver, and sell goods to clients, firms inevitably incur certain expenses. The most common ones are the costs of goods sold, selling and marketing, general, administrative, interest, and tax expenses.

Cost of goods sold (or COGS) are expenses incurred to produce the goods that a firm sells. Milky Way Inc needs to buy raw milk from local producers, transport, process, and package it before selling it to supermarket chains. It also sustains additional costs to produce cheese from the milk. Remember- expenses that directly derive from the production of finished products are registered as the cost of goods sold! We see that Milky Way spends roughly $29,000 million on production each year.

What’s more, companies bear some operating expenses. These are the ongoing costs for running the business, such as selling, general, and administrative expenses, often called SG&A. This category generally includes:

  • Marketing and promotional expenses
  • Office-related operating expenses (e.g. management and accounting team’s payroll costs)
  • Office rent, utility bills for electricity, phones, and water supply

It seems that Milky Way’s annual operating expenses are stable – approximately $10,000 million per year.

In terms of interest expense, we define it as the finance cost that a company bears for borrowing funds externally. Milky Way Inc. took a bank loan when it acquired a new milk processing system. The bank agreed to lend the necessary funds at an interest rate of 6%. That’s why every year the firm pays interest and other related finance expenses on the total borrowed amount. As you can see, it is recorded on a separate line in the company’s income statement, after the Operating Profit: $330 million in the previous financial year and $310 million in the current accounting year.

As far as tax is concerned, we need to know that every firm pays corporate taxes that are proportional to the amount of their Profit Before Tax. In the case of Milky Way, this will be $960 million and $910 million in the two consecutive years. Please note that tax rules may vary among jurisdictions.

Types of Profit

To satisfy different reporting needs, an organization’s Income Statement outlines four types of Profit. These are:

  • Gross Profit
  • Operating Profit (EBIT)
  • Profit Before Tax (EBT)
  • Profit After Tax (Net Profit)

The difference between the Total Revenue and Cost of Goods Sold is called Gross Profit. This is the profit a company makes after deducting its costs of production.  

Gross Profit = Total Revenue – Cost of Goods Sold (COGS)

Upon subtracting all distribution, sales & marketing, and administrative expenses from the Gross Profit figure, we get to the second type of profit, known as Operating Profit. It is sometimes referred to as “earnings before interest and taxes” or EBIT.

Operating Profit = Gross Profit – Operating expenses

By further subtracting Finance costs (such as interest expense) from the Operating profit, we arrive at Profit Before Tax, or “earning before tax” (PBT):

Profit Before Tax (PBT) = Operating profit – Finance costs

Once tax and all other expenses have been numbered in, we obtain the bottom-line figure- Net Income – also termed as Profit After Tax.

Net Income = Profit before Tax (PBT) – Tax expenses

This is the excess of revenues over total expenses. The Net Income figure is very important as it represents the profitability of a venture after accounting for all its costs.

Income Statement vs. Statement of Other Comprehensive Income

Below the Net Income figure, you will find a separate section called “Statement of Other Comprehensive Income”. It summarizes transactions that mostly affect stock owners’ equity (but don’t impact net income). For example, unrealized gains or losses from foreign currency translation, pension obligation adjustments, as well as unrealized gains and losses from derivative instruments or financial assets measured at fair value.

All these do not change the Net Income because they do not arise from the normal course of the business. They are reported in the Other Comprehensive Income section because they still affect owners’ equity. Examined in conjunction, the Income Statement and the Statement of Other Comprehensive Income sections altogether comprise the Statement of Comprehensive Income.

Beyond Income

To fully understand the financial health of an organization, one must review the Income Statement, Cash Flow Statement, Balance Sheet, and Statement of Changes in Equity jointly.

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