Financial statements are prepared and reported by all listed companies to present the financial position for a period to the stakeholders. Financial statements of a company have five main parts: the balance sheet, income statement, cash flow statement, notes to accounts and shareholders / owner’s equity.
In this article, we will be looking at the income statement. You will learn what an income statement is, how it’s prepared and what its purpose is.
Income statement is the first thing prepared by the company as all others are dependent on it. For instance, without net profit, you can’t prepare balance sheets, shareholders equity and statements of cash flow.
It’s also known as a statement of operations or profit and loss account or P&L.
Income statement of a company shows how much it earned or lost during the financial year by reporting total revenues and expenses for the period, generally a quarter or year. It basically summarises the earnings generated by a company during a particular period of time. The bottom line of the income statement is net profit or net loss for the period.
This means it reports profitability of the business by summarising revenues and expenses of a business over a period of time, usually either for 3 months or one year.
You can also define an income statement as a summary report of the revenue, expenses and net profit of a business entity for a specific period of time.
Income statement of a company has two major parts: revenues and expenses.
The basic equation used for an income statement is;
Net profit or loss = Total Revenues and gains – Total Expenses and losses
To find out net profit, first you have to list revenues, second list the expenses. Now subtract total expenses from total revenues to get net profit/loss. If the resulting figure is positive, it means your company earned profit. A negative number indicates that the company has earned loss, expenses exceed revenues.
Instead of calculating net profit or loss by using the above mathematical formula, companies prepare income statements in a summarised way to show how much revenue the company has generated during a period and what cost it has incurred in connection with generating that revenue.
In simple terms, a profit and loss account is an accounting statement that summarises a company’s sales, the cost of goods sold, indirect expenses incurred and profit or loss over an accounting period.
Net profit after paying dividend is transferred to retained earnings.
Income Statement or profit and loss account of a company answers three basic questions to all stakeholders:
- How much money came in? Or How much money the company generates during the period of time, known as revenue or sales or gross receipts of a company.
- Where did the money go? Or What costs the company incurred in order to generate that revenue, total outflow including direct and indirect expenses
- How much money is left? Or How much money the company is able to retain from its business activities for a period, known as net profit or retained earnings.
Components of Income Statement
A company publishes its income statement according to the prescribed format of the country in which it operates. It shows all the incomes and expenses according to the applicable rules and regulations.
Income statement is an accounting statement that summarises an organisation’s revenues, expenses, and profit/loss for a particular period of time, it can be for a quarter or year.
Companies may produce income statements for a month or for a shorter period of time for their internal use. These companies report quarterly and yearly financial statements for the benefits of outside stakeholders to update them about the company’s performance.
When you look at an income statement you will see followings;
- Revenue from operations or net sales.
- Operating profit
- Profit before tax (PBT)
- Tax expenses
- Profit after tax (PAT)
- Basic and diluted earnings per share or EPS
Revenue and net profit after tax (PAT) are referred to as “Top Line” and “Bottom Line” respectively.
Income statement is also referred to as a “statement of operations” or “statement of earnings”.
Financial analysts, investors, creditors and other stakeholders intensely scrutinise a company’s income statement after its publication. You must have seen in news channels how analysts always discuss a company’s present and future profitability.
Investors are interested to know earnings growth of the companies as based on high and low earnings growth, the market does the valuation. Credit analysts evaluate liquidity, cash flow and solvency factors.
Based on its importance, let us discuss various components of the income statement.
Revenue or Gross Receipt – Top line of the income statement
The first item you see in the income statement is the Revenue.
Revenue is the amount that a company has charged to its customers for the delivery of goods or services in the ordinary activities of a business.
Revenue is also referred to as the top line of the income statement.
Revenue is often used synonymously with following terms;
- Gross receipts
- Revenue from operations
- Total income
Typically sales is used to refer to the sale of goods. Gross receipts refer to the sale of services. However, revenue refers to both the sale of goods or services. In a few countries instead of revenue, turnover is used.
If you are seeing total revenue in the income statement of an accounting year, then it means the company has incurred that much money in that accounting year by selling its products or services to customers. Revenues are inflows to the business from providing goods and services to customers.
Revenue is not always reported as “total revenue”. Depending on the type of business, it’s sometimes reported as net sales, income from business or gross receipts. It’s also called the top line by investors.
Expenses shown against revenues in an income statement are the costs incurred by the company to generate revenues. Costs or expenses can be categorised to three major types: cost of goods sold, general and administrative expenses and other items.
Revenues and sales are used synonymously.
A company might have other income which is not directly related to its operation. They show these types of income as other income and add it to show total revenue of the company for the period.
Revenue from operation is the amount that the company has really sold to customers after customer’s returns, sales discounts and other allowances. Companies just show the net revenue figure on the face of the income statement and don’t bother to show returns, allowances, and the like.
How revenue is recognised in the income statement
As a fundamental principle of accrual accounting concept adopted by companies and countries, revenue is recognised when it is earned, even though the company does not receive cash until some later time. Therefore a company recognizes revenue when it’s earned.
When a company earns revenue, it gets added to the sales / revenue account and related accounts receivable. When the company receives cash, they reflect that the cash has been received and settle the respective accounts receivable account.
All the listed companies disclose their revenue recognition policies in the footnotes to their financial statements. By analysing these policies you can easily know how and when the company recognises revenue.
Remember, revenue recognition policies will differ from company to company based on the types of product sold and services rendered.
Cost of goods Sold (COGS)
Cost of goods sold (COGS) means the direct cost that a company has incurred in production to sell goods. COGS includes, cost of materials used for production, manufacturing overhead and direct labour cost.
COGS is shown in the Income statement of manufacturing, wholesaling and retailing companies as these companies are buying raw material to either produce finished goods or for resell.
In the case of service industries, such as information technology companies, financial services providers, you will not find the cost of goods sold in a P & L account.
It’s also termed as cost of sales or cost of goods consumed or COGS. It is deducted from the revenue recognized by the company to give you gross profit. Gross profit shows whether a company sold its goods and services for more than the cost they incur to produce it.
Gross profit is arrived at after taking out the cost of goods sold from its total revenue. This means gross profit is sales minus cost of goods sold.
It tells you how much the company has made during the period before expenses and taxes are taken away.
In the case of a service company, gross profit is calculated by taking out the cost of services from revenue.
Gross profit = Revenue – Cost of goods sold
You will not find gross profit, which is sales minus cost of goods sold, in income statements as it’s generally not reported. If an organisation is following a multi-step format for reporting, then they will show it in the Income Statement. From gross profit if you deduct operating expenses and taxes, you will get net earnings.
A company might incur various types of expenses in order to generate revenue. Expenses are deducted against revenue to arrive at the company’s net profit or loss.
Expenses are recognised by a general principle known as matching principle, which means matching costs with revenues. By using this principle, a company matches expenses with associated revenues.
This matching principle requires that the company should match its cost of goods sold with the revenue.
In general, expenses are categorised under following heads;
- Cost of goods sold
- Operating express
- Tax expenses
- Extraordinary items
Under expenses, they are generally categorised under different heads based on how a company incur expenses.
Operating profit, PBT and PAT all refers to how much money the company made after taking out certain types of expenses.
Casually an income statement is referred to as a “profit and loss” or “P&L” statement, as it shows whether the organisation made a profit or loss.
On the face of the income statement, against income and expenses lines items, you will find schedules or notes numbers. These notes are also part of a financial statement presented in notes to accounts.
Operating expenses shows how much money a company has incurred to run its business this year or quarter.
All indirect expenses such as selling, general and administrative expenses, travel, rent, interest on loan and depreciation are listed in this section.
Most of the indirect expenses such as office salaries, rent, travel, meals, lodging for sales people, and advertising are grouped as operating expenses.
Operating income of a company means the profits it generates from its usual business activities, before deducting interest expense or taxes.
Operating profit is calculated by deducting operating expenses such as selling, administrative, and research and development expenses from the company’s gross profit.
Operating income is often referred to as EBIT, or earnings before interest and taxes.
Operating income reflects the company’s underlying performance independent of the use of financial leverage.
How profit is reported in Income statement
In general, you will get three types of profit reported on the face of the income statement. The first one is Earnings before interest, tax, depreciation and amortisation (EBITDA). As the name suggests, EBITDA is the profit that the company earned before taking out interest, tax, depreciation and amortisation costs.
Next is Profits before tax. As the name indicates, this is the profit amount that a company has made before paying income tax to the government. It is also known as Earnings/Profits before tax (PBT).
Under tax express, you will find two heads, one is current year tax and the other one is deferred tax.
Current year tax figure is the amount that the company has incurred by paying income tax to the government for the profit that they earned.
Deferred taxes are the amount that the company has deferred to a future date due to different treatment of expenses under companies act and income tax act.
The last one in our list is Net profit or loss, also referred to as the bottom line of income statement and Profit after tax (PAT).
The difference between total revenues and total expenses is net profit or loss. If revenues are greater than expenses, the difference is net profit. Similarly, if expenses are greater than revenues, the difference is net loss.
Net profit or loss is always reported at the bottom of the income statement. It is often referred to as the bottom line of the company.
If the business lost money, the amount of loss will be shown within brackets or with a negative sign “-” just before the amount of loss. Some companies prefer to show it as net loss.
Net loss indicates that the company after taking out its cost of goods sold or services from revenue has not generated any money, instead it has lost money in doing business.
Net profit is often used synonymously with following terms;
- Net income
- Net earnings
Net earnings or profit is the single most relevant number that investors, traders, analysts and all other market participants are interested in.
Net profit describes the company’s performance for a period.
Earnings per share (EPS)
At the bottom of the income statement, you will find companies basic and diluted earnings per share. It’s the amount of earnings per common share of the company.
You can refer to our article “how to calculate basic and diluted earnings per share (EPS)” to know more.
As per law, companies are required to report certain items such as revenue, finance costs, depreciation, tax and EPS separately on the face of the income statement.
On the face of the income statement, you will find basic and diluted earnings per share.
EPS or Earnings per share is calculated by dividing the net income by the number of shares of stock outstanding during the period.
In calculation of basic earnings per share, the company uses the weighted average number of common shares that were actually outstanding during the period.
In diluted earnings per share, the company uses diluted shares, the number of shares that would be outstanding if potentially dilutive claims on common shares (e.g stock options) were exercised by their holders.
The bottom line of an income statement is known as net income or loss for the period. Net profit or loss is calculated by deducting total expenses out of total revenue or gross receipts. If you divide net profit by the average number of outstanding shares, you will get EPS or earnings per share.
High EPS shows that the company earns more earnings per share for you. Likewise, a low EPS shows that the company earns less per share for you. You need to compare it with industry EPS or against the EPS of another immediate competitor to know whether the earnings per share is high or low.
Company in its income statement, matches the revenue earned from selling goods and services against all the costs incurred to operate it. It’s always published for a period. This means if you are preparing an annual report, the income statement in it should be for the whole year. Similarly, for a quarterly report, the p & l account should be for the quarter.
Company for its internal purpose can also prepare an income statement for a month or for some other period.
Please note, retained earnings is the amount of net profit retained during the period, whereas in the balance sheet its the record of accumulated earnings less dividend paid since inception of the company.
Heading of income statement will have following details;
- Name of the company,
- Income statement, and
- The period of time the statement covers.
An example for the year ended March 31, 2022 is given below for your reference:
XYZ Technologies limited
For the year ended March 31, 2022
If the income statement is for the quarter ended, then the third section should be changed. For instance if it’s published for October-December 2021, instead of writing “For the year ended March 31, 2022“, you should write “For the quarter ended December 31, 2021“.
The end result of the income statement (revenue – all costs) is referred to as net profit or bottom line. In the case of a parent company which has investment in subsidiaries, the income statement is reported on a consolidated basis by including revenue and expenses of all affiliated companies under control of the parent company.
Companies, while publishing income statements for a year, present the most recent year in the first column and the earliest year in the last column. If it’s for a quarter, the most recent quarter is presented in the first column and then the same quarter of last year in the next column.
Income statement is prepared and published to give you information on the financial results of a company’s business activities over a period of time. It tells you how much revenue the company is able to generate for the period, what costs it incurred to generate that revenue and how much money the company is able to retain out of revenue after paying all of its expenses, known as net profit.
If you are looking at the income statement of a parent company in its annual report, then in addition to looking at the standalone figures you should also pay attention to consolidated financial results.
Consolidated financial results means they include financial information of affiliated companies under the control of the parent company.