After learning how to read the balance sheet and finding out what all these financial statements are good for, knowing how to read an income statement is a valuable addition.
Apart from determining the current financial health of the company, the income statement can help in predicting future opportunities and deciding business strategies.
What is an Income Statement?
An income statement (or Statement of Comprehensive Income or Profit and Loss statement) summarises all revenue and expenses over a given period. Like balance sheets, the income statements are often shared in quarterly and annual reports.
The main difference with a balance sheet is that while a balance sheet documents assets, liabilities and equity, an income statement quantifies the total revenue and expenses over a period of time.
Purpose of an Income Statement
The purpose of an income statement is just as its name suggests: to show the inflows and outflows of a company.
Using the income statement, we can tell if the company is making a profit or loss. Coupled with other statements like the balance sheet or cash flow statements, we can know for sure the financial performance and health of a company.
Further analysis will allow you to find out the circumstances surrounding their financial health, whether they’re spending more than they can earn, or which costs and the highest, how much does it take to produce a good, and whether there is a net profit after paying for all that’s due.
Components of an Income Statement
As mentioned before, an income statement consists of all revenues and expenses. But the main bulk of items are as follows:
- Revenue: The amount of money the business brings in
- Expenses: The amount of money the business spends
- Cost of Goods Sold (COGS): The cost of components parts of the product sold by the business
- Gross Profit: Total Revenue – COGS
- Operating Income: Gross Profit – Operating Expenses
*Operating expenses refer to any expense incurred for daily operations
- Income before Taxes: Operating Income – Non-Operating Expenses
- Net Income: Income before Taxes – Taxes
- Earnings Per Share (EPS): Net Income / Total Number of Outstanding Shares
- Depreciation: The value of assets lost due to time (aging equipment, wear and tear)
- EBITDA: Earnings Before Interest, Tax, Depreciation and Amortisation
These categories can be further broken down into further subcategories. For example, under expenses, there can be many subcategories, from rent expense, to interest paid, and wages. Companies may further divide these categories according to their business model and profile, in order to generate the most accurate picture for the readers of the income statement.
Summary
There are many ways of dissecting an income statement, with the most notable being the horizontal and vertical analysis, allowing the readers to uncover the information needed to make an informed decision (regardless of a business decision in terms of a business leader, or a buy/sell decision in terms of an investor).
It is important to note that just because a company is profitable in the income statements, it is a good company and you should buy into them. There are many other factors involved, which is why you should read the income statement in conjunction with other statements such as the balance sheet or cash flow statement!
