There are four main financial statements for any business, including: (1) balance sheet; (2) income statement; (3) statement of cash flow; and (4) statement of owner’s or shareholder’s equity. An income statement, also commonly referred to as a profit and loss statement or statement of earnings, is an important tool used to describe the profitability of a business.
The income statement provides a “bottom line” figure, or whether the business is functioning at a net operating profit or a net operating loss for a specific period of time. To describe the income statement simply, it tells you whether the business made money or lost money over a certain specified timeframe. Income statements most commonly are used to describe profitability for time periods of one month, one quarter or one year.
Information contained on an income statement include: (1) gross sales or revenue, (“sales” refers to a product-based business and “revenue” refers to a service-based business); (2) cost of goods sold (if the business is product-based); (3) operating expenses; (4) interest paid; (5) income taxes; (6) net operating profit or net operating loss; and (7) earnings per share.
Key terms defined:
- Revenue: Income received from sale of services;
- Sales: Income received from sale of goods;
- Cost of Goods Sold: Costs attributed to the sale of goods, including materials cost and labor costs;
- Depreciation: Expensing the cost of a capital asset over a period of years;
- Capital Asset: An asset with a useful life beyond one year, i.e. a company vehicle or business equipment such as a printing press;
- Interest: Finance charge on debt paid by borrowing company to lender;
- Earnings per Share: Amount of net income allocated to each outstanding share of stock.
Preparation of an income statement involves the following steps:
- First subtract the cost of goods sold from the gross sales. Only product-based businesses with be required to perform this step, since only businesses with product inventories will have a cost of goods sold figure. The difference between the gross sales and cost of goods sold is the business’ gross operating profit or gross operating loss;
- Second, deduct the business’ operating expenses from the gross operating profit or gross operating loss figure, providing an amount known as “EBIT,” or “earnings before interest and taxes.” Included among the operating expenses are amounts for the depreciation of capital assets. Depreciation is a way of expensing the cost of a capital asset over a period of time. A capital assets is an asset with a useful life beyond one year;
- Third, deduct the amounts paid for interest on debt and income taxes from the EBIT figure;
- Fourth, you are left with a net operating profit or net operating loss, also known as a “bottom-line” figure.
- Finally, divide the net operating profit or loss by the average number of average outstanding shares to determine the earnings per share.
Example of an Income Statement (product-based business)
In addition to telling you whether a business made or lost money over a period of time, the income statement also enables you to calculate a business’ profit margin. Profit margin is simply how much of each dollar of sales the business secures as profit, and is calculated by dividing the net income figure by the gross sales or revenue. We can determine the profit margin as follows:
Net Operating Income $44,700.00
—————————————————————— = .447 or 44.7%
Gross Sales $100,000.00
So for every dollar of sales generated by XYZ Corporation the company sees a profit of nearly 45 cents. In a vacuum this information may not be very useful. However the profit margin can be used to compare companies in the same industry to determine whether the company is controlling costs as effectively as its competitors, and can be used within the company to monitor improvement in cost control and profitability.
In conclusion, there are four main financial statements for any business, including: (1) balance sheet; (2) income statement; (3) statement of cash flow; and (4) statement of shareholder equity. An income statement explains whether a business operated profitably over a specific period of time, and can be used to calculate several useful financial ratios used in evaluating the performance of a business. Most notably, the income statement can be used to determine a business’ profit margin, which tells you how much profit is derived from each dollar of sales or revenue generated.