Income statement is a common term, but are you aware of everything it comprises?
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 made for that period. Then you subtract the costs and expenses of running the organization in a series of stages, beginning with the costs most closely associated with the sales.
Your top line reflects your sales, and your bottom line is how much money you have left after everything else has been taken into account. The income statement displays both those values and all the subtotals in between.
We’re going to travel through the income statement, tracing the calculation stages.
How to Prepare an Income Statement: A Series of Subtotals
At the very top of the income statement is the amount 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 subtraction involves the administrative expenses and all other expenses of running a business, including R&D and salaries.
When you subtract those, 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.
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 the income tax, you’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; 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 only impact the sales and direct costs of the product. The managers are responsible down until the operating profit. But only the senior people in the company have any control over the finance charges and taxes. These expenses depend on where money is raised and where the business or factory operates.
A Real-World Application
Here’s how this term is probably used in your office:
A sales manager might suggest that salespeople look at a customer’s income statement. This request aims 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 the 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.
Income Statement Limitations
There is a big difference between cash and profit. You may be profitable on paper while the customer still hasn’t paid yet. The income statement tells you whether you’re profitable or not, but it doesn’t tell you when you’ll get the cash from any sales you make.
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.
The Importance of the Income Statement
The income statement is one of the most important statements to reference to determine the state of a company. It is a pillar of financial reporting, along with the balance sheet and the cash flow statement. It’s a thorough revenue report and is highly beneficial as an observational tool for potential investors.
Visual finance is the most effective way to teach income statement information to all employees. Seeing the moving parts of the statement helps people learn far more effectively than just staring at the numbers on an income statement, regardless of their position within the company.
At Income|Outcome, we offer corporate business simulation training that utilizes visual finance to teach business acumen. The simulation game board shows the connections between an income statement and a balance sheet. Participants work through the simulation, learning to analyze the income statement and balance sheet. Participants then use the information to make business decisions and achieve the best financial results for the company.