What is an Income Statement?
An income statement is a financial statement that reports on a company’s profitability over a period of time. The income statement is also referred to as a Profit and Loss Statement (P&L). Or less commonly as a statement of revenues and expenses. While an income statement can be compiled for any time period, it most commonly summarizes a month, a quarter or a year. Also, it commonly shows a comparison to previous periods so the reader can understand the trend over time. Income statements commonly show the performance of a whole company. But can also be compiled for a business unit, location or even a project.
When business leaders ask “what’s the bottom line?” they are referring to the income statement. Since the bottom line of the income statement is Net Income – a measure of profitability. This expression has been expanded to mean a meaningful and measurable impact on the business. Similarly, when business leaders speak of adding to “the top line”, they are referring to revenue since that’s at the top of the income statement.
Income Statement Key Concepts
Before you start looking at line items an income statement it is useful to define some core concepts of accounting and financial reporting.
Revenue vs Sales vs Cash Receipts
Revenues are not the same as cash inflows, but they are commonly confused. The main difference is that Revenue is recorded when earned and show on the P&L on whereas Cash is recorded when received and shows on the Cash Flow Statement. For instance, a company may take a deposit up front, but not earn the revenue until the product is delivered. Or a company may invoice their client for services rendered, thus recording revenues earned, but not receive the cash until 60 days later. Decisions and policies about when to recognize revenue (i.e. Revenue Recognition) should be made with the assistance of a CPA.
Sales and Revenue are two concepts that are also commonly confused. The terms are used interchangeably even by accountants at large companies! Sales refer to an executed contract for the provision of goods or services. Whereas Revenue indicates earned income. For instance, a sales rep may close a ‘Sale’ for a $100,000 project in a given month. The company may then start work and earn $25,000 of Revenue in each of the next four months, and Receive Cash 30 days later.
Cost of Sales and Gross Profit
Just below Revenue on the income statement, you’ll find Cost of Sales (COS) or Cost of Goods Sold (COGS). This line item attempts to describe the expenses that are directly associated with the revenue earned. It can include the cost of inventory sold, wages of project team members, subcontractors, etc.. Determination of what expenses to include in COGS should be done with the assistance of a CPA with management accounting expertise, and is related to the concepts of fixed vs. variable costs, direct vs. indirect expenses.
Gross Profit = Total Revenue – Total COGS.
Subtracting COS from Revenue gives the Gross Profit for the period. Therefore, if Gross Profit is negative, no amount of increased sales will result in a profitable company.
Expenses vs Assets and Cash Disbursements
Not all cash outflows are recorded as expenses on the books, and therefore don’t show up on the income statement. Purchase of equipment is an obvious example – equipment is an considered an asset that will be used over a long period of time and can feasibly be sold in future. Less obvious examples are when R&D focused companies choose to capitalize some of their development expenses. Capitalizing expenses creates assets on the balance sheet and these decisions and policies should be made with assistance from a CPA – they have important impacts on business valuation, M&A and eligibility for tax credits.
Not all expenses are associated with cash outflows. Similar to the concept of Revenue Recognition, companies must decide when an expense has been incurred. For instance, companies may prepay their insurance premiums all in one lump sum, but spread out the expense on a monthly basis in the books, so the cash transaction is separate from the expense. Similarly, the concepts of Depreciation and Amortization relate to how much of an asset’s life has been used up. Some amount of depreciation expense is recorded on the books each year but does not affect cash.
Net Income vs Net Operating Profit
The Net Income “bottom line” is ultimately what matters, as it reflects the overall profit earned by the company. This is also known as Net Profit. But some of the expenses a company incurs are more related to how it chooses to finance itself than the profitability of its regular business activities. Some companies may pay high interest on credit cards and operating lines of credit. Whereas others may have a lower debt service load. Net Operating Profit considers the profitability of the daily operations with financing expenses removed – i.e. considering only the operating expenses.
Net income = Revenues – Expenses
For the same reason it is also interesting to look at Income Before Taxes – some businesses may be more tax efficient than others and you may want to consider only the operating profit.