Along with the balance sheet and cash flow statement, the income statement is one of the “big three” financial reporting documents that every public enterprise must produce quarterly. It is a summary of a company’s performance, determined by the profitability of the organization over a period of time. It is also known as the income statement (P / L) or income statement.
This document provides investors and stakeholders with a context on how effectively the company manages its revenues and expenses. It is also an excellent assessor of performance over time. Savvy investors can learn a lot about running a business, its operations and how it performs against the industry by surveying the income statement.
Reports in accordance with generally accepted accounting principles (GAAP)
Like other large financial statements, companies must prepare their income statement according to GAAP. This means that the document itself must meet double-entry accounting standards and GAAP standards to qualify and contextualize income, expense, and profit. In addition, income statements should be clear about the period to which they report. For example, many statements include a qualifier that reads: “For the fiscal quarter ended March 30, 2021,” or similar.
According to the Securities and Exchange Commission (SEC), public companies must produce quarterly and annual income statements. Investors will find the income statement packaged in a company’s 10-K or 10-Q folder, alongside the balance sheet and cash flow statement.
Income, expenses and profits
The income statement has three distinct sections: income, expenses and profits. At a glance, it tells investors everything they need to know about the company’s ability to generate profits (or losses). Each section of the statement is delimited by lines which summarize the different treasury activities.
- Income represent net sales and gross income, as well as miscellaneous income.
- Expenses show the cost of selling and selling, as well as administrative costs.
- Profit shows the gross profit, operating profit, profit before tax and net profit of the company.
In these sections, companies declare operating and non-operating costs. Operating income and expenses are those that are directly related to goods or services. Conversely, non-operating income and expenses include those that are not part of day-to-day activities, such as the sale of investments.
While it is likely that there are many line items incorporated into the income and expense sections, the income statement itself follows a very simple equation:
Net Income = (Total Income + Gains) – (Total Expenses + Losses)
Net profit is the bottom line that indicates whether the business is profitable. And while this is an important metric at a glance, investors should delve into the entire income statement to understand exactly what is contributing to that number, positive or negative.
Interpretation of the income statement
When investors look at a company’s income statement, they see top and bottom digits. Top row the figures are those relating to sales and income; net profit the numbers are those related to income. Typically, income equals sales and expenses dictate what the results will be.
Ideally, a healthy business will show steady increases in income and static or declining numbers in the expense section. More sales and income show the company’s ability to sell more and acquire new customers, thereby promoting revenue growth. Fewer or declining expenses indicate operational efficiency, indicative of savings to the bottom line. Investors are looking for both.
What happens if expenses exceed income? This means that the business is operating at a loss for the period indicated in the income statement. This is not uncommon, especially for growing businesses. If it persists for several quarters, it can be a worrying sign that eventually leads to insolvency.
In short, the more money the business makes and the less it has to spend, the more profitable it is.
How to use an income statement
Since income statements represent an extract over time, they are best used as representation of trends over time. For example, an investor can compare a company’s revenue growth quarter to quarter or year to year. Or, they can look at expenses incurred by a business at a pivotal time in the year to predict future income in an upcoming quarter. The income statement provides a framework for understanding how the business operates over time.
Since income statements follow GAAP standards, they are also useful for comparing competitors. For example, if Company ABC has similar income to Company XYZ, but almost double the expenses, it is worth digging deeper to see why. Is it inefficient management? Higher COGS? Deepening financial reporting can provide context on how a business is performing relative to its peers.
Most income statements provide context, whether it is the previous quarter or the next three years. This provides a quick context for the movement of the company’s income and expenses. Investors don’t have to stalk the data – it’s a matter of comparing two numbers side by side on the statement.
Pay attention to income statement trends
The most valuable part of an income statement is the accounting period it represents. While it’s nice to have insight into the operations of the business, what’s even better is seeing income and expense data increase and decrease over time. If the company’s sales are up and its expenses stay the same or go down, that’s a sign of good health. If revenue growth is flat and the bottom line is heavy, the business needs to re-evaluate its operations.
Remember, it’s best to use the income statement along with the balance sheet and cash flow statement as part of a comprehensive review of business finances. Context is important, especially when you are only looking at the numbers for a specific accounting period. And this information is invaluable to investors preparing for retirement. To find out more, subscribe to Rich retirement e-letter below!