“Income statement” is a common term, but are you aware of everything that comprises it?
An income statement is a history book of the sales, costs, and expenses over a given period of time. Publicly traded companies are required to publish them.
To calculate the income statement, you start by looking at the sales that have been made for that period, then subtract—in a series of stages—the costs and expenses of running the organization, beginning with the costs most closely associated with the sales.
Your top line reflects your sales, and your bottom line is however much money you have left after everything else has been taken into account. The income statement displays both of those numbers, as well as all the subtotals in between.
We’re going to travel from the top of the sheet down to the very bottom, tracing the many stages of calculation that exist within an income statement.
The Stages of an Income Statement: A Series of Subtotals
At the very top of the income statement is the amount of money you make from sales. Hopefully, it’s a nice hefty number, but don’t fixate on it: we’re about to cut it down.
The first subtraction you make from that number is the cost of sales. The cost of sales is whatever expense increases every time you make an additional sale. For example, if you sell another hamburger, you are using up another bun and patty.
Your first subtotal is called your contribution margin.
Next, you look at all the other expenses associated with the site where the activity happens. These could be factory- or restaurant-specific, or more general costs such as electricity, water, and the depreciation of assets. Also include any other site overheads at this stage.
Subtract from the previous subtotal. The new number is your gross margin.
The next stage of subtraction involves the administrative expenses and all other expenses of running a business. This includes R&D and salaries.
When you subtract those out, the next subtotal is your operating income or earnings before interest and tax. It’s known by several different names, but they all mean, in effect, the operating profit for the company–the day to day profit, not taking into account the income tax or the cost of loans.
Below that, you have the finance charges associated with borrowing money, issuing bonds—or wherever you’re getting the money to run the business with.
Subtract that number to receive your taxable income.
And finally, you have the taxes you pay on whatever you had left in the way of profit.
Once you’ve subtracted out the income tax, you should’ve taken care of everything. If so, you are down to your net income, the final line (and stage) on the income statement.
The income statement is sometimes called a Profit and Loss (P&L) statement, and each line on it might be called different names by various companies. But the essential structure of an income statement will always be the same. There are slight exceptions, but they are rare.
There is another notable aspect of the income statement’s structure. The further down the income statement you have control, the more senior you are in the company.
The frontline employees really only impact the sales and direct costs of the product. The managers are responsible down to the operating profit. But only the very senior people in the company have any control over the finance charges and taxes, because those depend on where money is raised and where someone decided to run the factory or business from.
A real-world application
Here’s how this term is probably used in your office:
A sales manager might suggest that salespeople should look at a customer’s income statement. The purpose of this request is to see if the customers are profitable or running on razor-thin margins.
If they’re profitable, the salespeople shouldn’t need to give as much ground on price. And if they are on razor-thin margins, the salespeople might be able to offer them a bulk discount so that they’re not paying as much per unit. That is, if the customer won’t mind carrying an inventory for a longer period of time.
The P&L tells you whether you’re profitable or not, but it doesn’t tell you when you’re going to get the cash from any sales you make. You may be profitable on paper while the customer still hasn’t paid yet.
It also doesn’t tell you if you’re making good use of your assets, or if you’re going to stay afloat. When you don’t know when cash will come in, you don’t know if you’ve got the cash flow to survive.
Still, there’s a good reason the income statement is widely used. It’s a very thorough report on revenues, and it’s highly beneficial as an observational tool for potential investors.
It’s one of the most important things to reference to determine the state of a company and, along with the balance sheet and the cash flow statement, it is a pillar of financial reporting.
P.S. The most effective way to get the information on income statements into your bloodstream is through “visual finance.” The Income|Outcome simulation reflects all the elements of an income statement on a three-dimensional landscape. Actually seeing the moving parts helps the user to learn far more effectively than they would by just staring at the numbers on an income statement.
If you’d like to learn more about participating in a visual finance simulation, contact us.