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If you've already learned about and understand balance sheets, let's move on to the next financial statement, the income statement, also called a “Profit and Loss Statement”.
Unlike the balance sheet, which looks at a company’s financial position at a specific moment in time, the income statement reflects performance during a period of time, typically a calendar year or quarter. Let’s continue with our fictitious ABC Corporation and have a look at its income statement below.
|Cost of Goods Sold (COGS)||$60,000|
|Research & Development (R&D)||$5,000|
|Selling, General and Administrative Expenses (SG&A)||$45,000|
|Earnings Before Interest & Taxes (EBIT)||$40,000|
As with our sample balance sheet, your company’s income statement will not look exactly like this one (it may be missing some of our entries and contain some additional line items), but it should follow the same general pattern. It will start with a figure labeled total revenue or perhaps net sales—which is essentially the same thing—at the top, and then break down various expenses before concluding with a net income (or loss) figure on the bottom line. This is why people often refer to a company’s profitability as “the bottom line.”
Let’s go through ABC’s example line by line and see if we can start to get an understanding of some of the major items that you can except to see on an income statement:
The next section of our income statement breaks down a group of costs known as operating expenses, which include things like salaries, office supplies, and other items that are essential to the day-to-day functioning of a business. If an expense can’t be included under COGS (i.e. it is not directly related to the production of a good or service) then it should appear as an operating expense. ABC’s operating expenses are divided into the following two entries:
We now move on to the operating income section of the income statement, which in our case contains these four items:
Let’s start our income statement analysis by calculating a very important financial ratio, gross profit margin (also known as gross margin). The math here is about as easy as it gets...
Gross profit margin is equal to gross profit divided by total revenue.
In ABC’s case, we come up with a gross profit margin of 0.60 or 60% ($90,000/$150,000). Gross profit margin can be thought of as a measure of efficiency, it tells us how much money is left over from sales after accounting for the cost of the goods sold. While average profit margins vary greatly from industry to industry, as a general rule a higher gross profit margin indicates a more efficient company within its field.
The next figure we want to calculate is operating income or operating profit, as it is sometimes referred to. Once again, the math is simple:
Operating income is equal to gross profit minus operating expenses ($90,000 - $5,000 - $45,000 = $40,000 in our example).
Operating income puts a dollar figure on the amount of money that a business is generating from its core activities and is closely watched by lenders and investors as a gauge of a firm’s ability to repay loans or pay dividends to investors. If a business is experiencing growth in its operating revenues, then it will have more money available for expansion, debt repayment, or any other management initiatives. The converse is also true of course, so if your business’s operating income has been steadily declining, this should give some cause for concern.
Now let’s go ahead and calculate ABC’s operating margin, which is equal to operating income divided by total revenue ($40,000/$150,00) or 26.67%.
Operating margin tells us how much a company keeps from each dollar of sales, before it has to pay interest and taxes. As with profit margins, averages will vary among different industries, but the higher the figure, the better. Looking at your company’s operating margins over time, by comparing different years’ income statements, can be an effective tool to measure how effective your firm is at keeping what it earns in sales revenue. If your revenues are increasing but your margins are shrinking, it may be time to assess whether those additional revenues are worth the money it costs to acquire them.
So, hopefully, now you have an idea of what the income statement can tell you about your business and how to calculate some simple, yet important, ratios that will also be of interest to lenders and investors. As with our discussion of balance sheets, this is not meant to have been an exhaustive analysis. We have left out a discussion of some of the more complex items that can appear on the income statements of large corporations, such as amortization and depreciation.
In any event, you should now have the tools to understand a good deal about your own company’s income statement, and if you wish to read further, we’d once again recommend an introductory undergraduate or MBA-level financial management textbook.
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.