Income Statement

What is an Income Statement?

The income statement is a key financial statement that summarizes the revenues, expenses, and gross or net profit (and losses, if any) for the period. The Income Statement, or profit and loss statement, is the first statement on an organization's annual financial reports. 

It allows the reader to see the income the organization or individual received, as well as the expenses they paid. This will enable them to gain an understanding of the reporting company's performance in their day-to-day operations. 

The statement is easy to understand; when the revenues exceed the expenses, this means the organization made a profit. However, when the organization had expenses that exceeded the revenue, it made a loss.

This statement is one of the three most important financial statements, along with the balance sheet and the cash flow statement, as it allows the reader to fully understand how the organization has performed in the reporting period. 

This statement is one of, if not the most important financial statements to stakeholders. Potential investors use it to decide on the organization's stock and whether they should buy or sell it. Lenders also use it to determine if they will lend the organization money. 

It can also be used to benchmark against competitors to further understand the organization’s performance. By examining industry performance, the reader will get the complete picture and make decisions accordingly.

The statement subtracts the expenses incurred from the revenue made by the organization, which shows the report reader the organization's level of profitability. This allows them to make the best decision about the organization's ability to make a profit.

It can also be used by management to decide which expenses to cut to increase profit margins. It gives the report user a clear view of each expense incurred by the organization and its values, so any expenses deemed too high can be eliminated in the next reporting period. 

understanding the Income Statement

The financial statement shows the organization's performance in terms of the money it receives for its key business dealings (revenue) and the money it spends to gain this money (expense) over a certain period.

Also, the gains and losses that occur over a reporting period. This is added after the revenues and expenses as it is money received or lost by the organization and must be reported. 

Separating the values from the extraordinary income from the actual revenue and expenses allows the report reader to understand that these values do not occur in the ordinary course of business and will not happen every period.

It is a way for an organization to understand how much they are spending to make the money they are making. It allows them to see how much profit they are making and, in any way, they can better improve their efficiency.

Individuals also use the income statement as a way to find out how much they are making, and it allows them to make better decisions when they are budgeting and finding which expenses they should eliminate. 

When a large organization completes them, it also adds the statement of comprehensive income, which includes any changes in equity as well as certain unrealized gains.

They aid gains and losses, which are usually extraordinary events (meaning they aren’t going to be consistent like sales). These gains and losses are also added to the income statement as they are inflows and outflows.

Components of an Income Statement

The Income statement is divided into a few key components. These components are:

1. Revenue

This area shows the money received. It is the money received directly by the organization in its day-to-day business dealings, such as the payment it receives from selling products and/or services.

This component is one of the most important components to any organization as it is the main driver of profit. It is the most important indicator of an organization's chances of survival and growth. 

Accounts that come under revenue are:

• Revenue: This is the money received from the main business the organization is engaged in. When the organization has multiple forms of revenue from its different business segments, it is all added here.
• Other Revenue: This is the additional revenue an organization receives. Most revenue is received from interest and revenue received from the rent of other properties owned by the organization. 

2. Cost of goods 

This is the money spent to make money. It is the direct cost of making the revenue in the component above. It includes raw materials and the process of making the final products.

3. Gross profit

This is the value that is gained from subtracting the two components above. It is the profit the organization makes without taking into account the more indirect expenses. 

4. Expenses 

These are more of the indirect expenses used to make the revenue. Examples are wages, rent, and advertisement expenses. 

5. Tax 

This is the levy paid to the government on the profit made on business profits. When an organization has a loss, they do not need to pay any taxes, but the loss can be offset against future periods the company has to pay tax. 

6. Income from extraordinary events  

This section of the statement deals with the income or losses that are the consequences of extraordinary events. Events that will not occur on statements like gains on the sale of an asset or impairment losses.

7. Net Profit/loss 

This is the profit made when all expenses are subtracted from the revenue. This is the amount the organization gets to pocket at the end of the period. 

When revenues are less than expenses, there is a net loss. Therefore, the organization lost money in the reporting period. 

What is the purpose of the income statement?

The statement has many purposes for many different types of report users. Some of the uses of the statement are as follows.

Decision Making

One of the primary purposes is the ability it gives the reader to make informed decisions about providing resources to the organization.

From managers to potential investors, it allows them to see many factors of the organization's dealings and enables them to make the decisions that will best benefit them.

Lenders also examine the statement to analyze the organization's ability to repay the loan. If they see that the organization is making consistent profits, they may decide to give it the loan; however, if it is not making consistent profits, they will not. 

Benchmarking

There are many ways the organization can benchmark its statement. The first is against industry standards, which will give the organization an average to compare itself to.

The second way that an organization can benchmark is against competitors. This is when the values of profit and revenue are compared to the organization's direct competitors, showing which company is performing better.

The final way to benchmark is by benchmarking against their historical performance. This will allow the readers to find trends and develop strategies that will enable the organization to perform better. 

Profitability

Another purpose is to show the profitability of an organization. This is one of the primary purposes of a business is to make a profit, so this allows the profitability of the organization to be shown.

Having gross profit, profit before tax, and net profit shows how the organization is performing on multiple levels. First, it shows how revenue lines up with direct expenses, then indirect expenses, and finally, against taxes. 

Including expenses also shows the biggest threats to profitability, and they can be converted into percentages to see their weighting. 

Gaining Investors/Lenders 

Potential investors are analyzing the reports of organizations as a means to better understand where they are putting their money. In addition, the statement allows them to see the organization's revenue and enables them to identify any risks they may be facing.

Lenders also examine the statement to ensure that a steady stream of revenue is entering the organization and that the profit margins are high enough to pay back the loan and interest.

Users of the Income statement

There are many different uses of the statement, and each user has various reasons for using it. Although all the users of the statements have common indicators, they all look for them when analyzing financial reports.

The stakeholders that make use of the income statement are:

• Management: The management of an organization uses it to understand the profitability of an organization. They use it to make decisions and develop strategies to perform better in future periods. 
• Shareholders: These are the members who have a financial interest in the organization's performance. They use this information to analyze the share price of the organization and decide whether to sell or hold their shares. 
• Competitors: The competition uses it to benchmark their performance against that of the organization. They can use their findings to better compete with the organization. 
• Creditors: The organization's creditors look at it to decide if the organization can meet its short and long-term financial obligations by looking at the profits they are making from different reporting periods. 
• Suppliers: These are the stakeholders that provide the product to the organization, and they analyze the organization's ability to generate income and decide if they will be able to pay back the amounts they owe on credit.  
• Potential investors: The statement is essential for potential investors as it shows them the profitability of an organization. Analyzing historical data and comparing the profits and losses over the years will determine if investing in the organization is worthwhile. 
• Other groups: Other users of the statement use it differently. These might include the government, lobby groups, employees, etc.

Benefits of the Income statement

Preparing the profit and loss statement accomplishes a lot for the organization and the readers of the information provided. In addition, the statement provides the following benefits:

It Directly Shows The Profits

The first benefit of the statement is that it shows the revenues made by the organization. One of the key indicators of performance of the money they make, and the statement shows that and when in the financial report, the notes allow the reader to see the breakdown.

The statement also shows the expenses, which are one area the organization must control to ensure they make profits. If the expenses are too high for one period, the organization can look at the income statement and identify costs that are causing and take steps to minimize them. 

Allows The Investors To Analyze

The statement is one of the most important for investors to analyze, as it contains the most important information that affects the share price. Investors can use the statement to determine whether the organization's share price is correct or if there is a way to make a profit. 

The gross margin and the profit margin are ratios that can be used to analyze the financial statement. These ratios examine the organization's financial health and can be used to benchmark performance.

Forecasting Performance

The profit and loss statement can be used to forecast an organization. Based on historical performance and growth rates, the organization can make assumptions about how it will perform over the next few reporting periods. 

This will allow them to benchmark the forecasts against the actual, and as time goes on, they will become better at forecasting performance in future reporting periods. It also allows the organization to better prepare for some poor performances and understand the reasons.

It Is A Tool For Better Decision-Making 

The profit and loss statement allows an organization to make better decisions. It allows the organization to gain more information about its performance. The organization can see what allows it to make more money and any costly areas that are decreasing its profitability.

Using profitability ratios like gross margin and profit margin allows an organization to make decisions about its expenses and ways to decrease them to increase the ratios. 

Limitation of the Income Statement

Although it has many benefits, it also has some limitations that can negatively affect the organization. The limitations are as follows.

The Statement Is Easily Manipulated

The major limitation is that it can be easily manipulated. One area that can be easily manipulated is the expenses. Some managers may want to get bonuses for reaching targets and may use creative accounting techniques to do so.

Depreciation is set low to reduce expenses, therefore increasing profits. These tactics are very misleading and may lead the reader to believe that the organization is performing better than it is.

It Doesn’t Take Into Account Certain Factors

One thing about the income statement is that it only considers financial aspects. The statements don’t take into account factors like productivity and efficiency. An expense may cost more than alternatives, but it is of better quality and leads to more revenue,

However, if an organization were to act solely on the profit and loss statement, it would be neglecting all the other factors that are at play that influence an organization's performance in the reporting period.

It Can Be Seen As Negatively

In some cases, the statement can work against the organization. For example, if the organization is making bigger profit margins, more users will analyze its statements. 

The more money an organization makes, the more its statements are thoroughly looked at. An example is an organization that is constantly making profits that increase over periods yet do not increase wages. This may lead to some boycotts and strikes, which will cost the organization more money down the line.  

It Could Lead To Bad Decisions

The fact that the statement only considers financial aspects may lead to the organization making bad choices to decrease expenses, which may lead to more problems down the line.

An example is if the organization has an expensive but socially and ethically responsible production process. They may decide to forego that process and choose cheaper but socially irresponsible options, which may lead to lawsuits or boycotts in the future.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Accounting Profit vs. Economic Profit

• Balance Sheet

• Cash Flow Statement

• Profit and Loss (P&L) Statement

• Profit Margin