Business owners, stock investors, accountants and leaders within a company all need to understand the income statement. Also known as the profit and loss report, the p&l, or the statement of earnings, the income statement is one of the three main financial documents. This document outlines a company’s revenue, expenses and profit for a specific period of time.
Despite the numerous line items and sea of numbers, the income statement isn’t very challenging to digest and get through. If you’re wondering ‘what is an income statement’ or ‘what does an income statement show me’ – this article is for you!
How Does an Income Statement Work?
The income statement shows how much revenue a company earned, and how much the company spent on expenses, within a specific period of time. Once you add up all the revenue, and subtract all the expenses from the revenue, you’ll land on the bottom line. This bottom line will show how much profit business made or loss within a specific period of time.
What Is the Main Purpose of an Income Statement?
The main purpose of the income statement is to organize and summarize all of a company’s revenue and expenses within a specific period of time. The income statement measures profitability, which could be a positive or negative number.
What Does the Income Statement Tell You?
The income statement shows the viewer how profitable a business was for a singular point in time. Not only does it show the bottom line, profit, it shows how the business got to that number.
To bring more value to the income statement, its best to leverage some trailing data. Instead of looking at a singular month, look at the trailing 12 months, or the trailing 3-5 years, to see how the business has performed and what the trend is.
What Is the Formula for Income Statement?
There are quite a few formulas one could look at on the income statement. Some formulas measure operating cost efficiency, others measure profit margins. With that said, the most important formula is a simple math equation.
Revenue – All Expenses = Net Income
Net income is the amount of money a business has kept, or loss, after all expenses have been deducted from the total income line item. Said differently, net income is the bottom line, which is the most important line on the entire income statement.
What Are the Limitations of the Income Statement?
Despite how useful the income statement is, there are some limitations. The most common limitations are:
- The intangibles, such as brand loyalty and customer experience, are not represented on this financial statement: The income statement simply measures the revenue and expenses a company has for a specific period of time. The customers experience and loyalty to the brand can make/break a company, and without question they have tremendous value.
- The income statement does not indicate the frequency of expenses: For example, the company may have $50,000 in vehicle expenses in a given month. Is that $50,000 expense recurring, or is that a one time expense? You’d have to look at numerous data points (months) to get an understanding of the cadence.
- It does not show how much debt a company has: It does in fact show the interest expense a company paid on the debt it has borrowed, but it doesn’t show the outstanding debt amount. Investing in a company that has a mountain of debt can be concerning. One may wonder why the company isn’t generating enough free cash flow to reduce its need to borrow money.
- Accounting nuance can dramatically change the income statement: Without getting too technical, how a company depreciates assets, and the lifetime of a given asset, can sway the income statements direction.
Where to Find an Income Statement
Publicly traded companies are required to publish their financial statements. These financial statements can be found on a variety of websites. A great resource is www.finance.yahoo.com
If you’re looking for a specific company’s statements, simply type in the company’s ticker symbol in the search bar. Once loaded, navigate to the “Financials” tab. You’ll be able to select your aggregation period, time period, and you can download the information into Excel.
What Are the Key Features of the Income Statement?
The meat and potatoes of this statement are the following buckets:
Revenue
Revenue, also known as sales or income, is the amount of money the business charged customers for their product or services. It’s important to note, revenue is not how much money the company actually kept.
For example, imagine you own a lemonade stand and charge $1 per cup of lemonade. In June you sold 5,000 cups of lemonade to your customers. You collected $5,000 in revenue for that given period.
Expenses
Following the above example, you now need to subtract expenses from that revenue figure. Your expenses are:
- $500 in sugar
- $500 in water
- $1000 in cups
- $500 in lemons
- $1.000 in payroll
All in all, your expenses for the month of June were $3,500. A large business will have a longer list of expenses, including operating expenses, electricity, rent, vehicle expenses, payroll, benefits, and the list could go on and on.
Gains
Continuing on the lemonade stand example, the business had $5,000 in revenue and $3,500 of expenses. This resulted in a $1,500 gain, or profit, for the owner. This is the “bottom line.”
Losses
Sometimes the bottom line is negative, and that can be okay. Businesses go in cycles. One month may be a down month, and the following month may be a record setting high. Never judge a business on a single data point. Look to establish a trend, and see if the trend is improving over time.
What Are Its Key Calculations?
In addition to this financial statement’s key features, certain calculations made on this statement are vital for understanding a health of a company.
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is one of the most crucial calculations on this financial statement. This EBITDA measurement is used by investors to determine the operating profitability of a company. In addition, it can be used to calculate an overall firm’s cash flow.
The formula for EBITDA is the sum of the firm’s net income, interest, taxes, depreciation, and amortization.
Additionally, it is a useful tool when examining and comparing one firm’s capital to others within that industry. Overall, this profitability ratio can showcase a firm’s operational efficiency at a specific point in time.
EBIT
Although it sounds similar to EBITDA, EBIT stands for Earnings Before Interest and Taxes. This is also a profitability ratio that showcases a firm’s earning ability in a specific period of time.
Similarly to EBITDA, EBIT’s formula is the sum of a company’s net income, interest and taxes.
The key difference is that EBIT focuses on how much income a firm produces whether as EBITDA focuses on the firm’s cash flows. Meaning that EBIT is more centered on the internal functions of a business.
Earnings Per Share
Earnings Per Share (EPS) is a tool investors use to determine how much profit a firm is generating off each of its stocks. Even though it is not clearly stated on the income statement, its key components are on it. The formula for EPS is:
EPS = (Preferred Dividends – Net Income) / Shares Outstanding
When EPS is at a high value it indicates that a company’s stock could continue to increase in price. Showing that there is potential profit growth for a company.
Price to Earnings Ratio
Price to Earnings Ratio (P/E) is another profitability ratio used to indicate whether a company’s stock is over or undervalued. Since its key components are also derived from the income statement, its formula is:
P/E = Share Price / Earnings Per Share
A high P/E ratio could potentially be a great signal to investors since it exemplifies that there is an excepted high return on a company’s stock. However, since this return is “expected,” the same high P/E ratio could also signal that a firm’s current share price is overvalued. It is important to analyze other key components of the company to have a better understanding of its P/E ratio.
Return on Equity
Return on Equity (ROE) is a commonly used measurement to determine a company’s financial performance. The formula of ROE is:
ROE = Net Income / Shareholder’s Equity
This ratio showcases how well a company has been utilizing its shareholder’s contributions within its business. For example, a low ROE indicates a poor usage of a company’s capital whether as a high ROE tends to be a good sign of capital allocation.
How To Read Income Statements
Income statements can be read a variety of ways. Some folks like reading it from the bottom to top, but the vast majority of people will read the income statement from top to bottom.
Start with your revenue, and then closely examine all the expenses. Each expense will chip away at the profit for the business. One of the most common practices you can do to better understand an income statement is to benchmark everything has a percentage of sales.
For example, for June the lemonade stand paid $1,000 in payroll, or 20% of the month’s income. In July, perhaps the lemonade stand does $5,500 in revenue, but payroll jumps to $3,000.
Why did payroll jump from 20% of sales in June to 54% of sales in July? These are questions stockholders and the management team will be asking.
Advantages of the Income Statement
The income statement has many advantages. These most commonly include:
- The income statement clearly shows how much revenue a business has generated: Over a period of time it shows the revenue, in addition to what their expenses are. With simple math, one will be able to identify trends when they compare the current income statement against a previous income statement.
- The income statement can be a great forecasting tool: Once you’ve established a trend, you’ll be able to get an understanding of what the future should do. Not only is forecasting important for people inside the company, it’s also important as an outside investor.
- The income statement allows you to compare similar companies against each other: For example, imagine if you were investing in Pepsi or Coca-Cola. One of the equations you’re looking to solve for before investing is, what company has the highest profit margin? You’ll easily be able to get this information directly from the income statement of both companies.
Income Statement vs Statement of Earnings
The income statement has a variety of names and is often called the statement of earnings. Simply put, the net income figure, or bottom line, represents the true earnings of the business. Therefore, many people prefer to call this report the statement of earnings as it really doesn’t matter what the income figure is, it’s the bottom line that counts.
The Bottom Line
The income statement is one of the three main financial statements. This report simply shows how much revenue, expenses, and profit a business made for a specific period of time. Reading the report from top to bottom will give you a good sense of where the company is spending money, and what expenses have the biggest impact on profitability.
Despite the simple math required to get through an income statement, there is a great detail of nuance that goes on behind the scenes. Simply looking at the bottom line will give you an idea of how much profit the business has generated, but remember, that is only one data point. There are numerous other ratios that are all helpful in determining the efficiency and risk of a business.
Working with a financial advisor is a great way to ensure you’re investing in a company that is suited for you, your goals and your lifestyle. Financial advisors are educated in hedging against risk, diversifying your investment portfolio, and analyzing which investments are best suited for you.