Lists all the revenues and expenses of a company in a given year and the deferential is the net income/loss
One key financial statement utilized by report users is the Income Statement, or as it is better known, the profit and loss statement. This is the first statement that appears on the annual financial reports of an organization.
It allows the reader to see the income in 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. Looking at the industry performance, it will allow the reader to get the complete picture and make decisions accordingly.
The statement subtracts the expenses incurred from revenue made by the organization, which shows the report reader the level of profitability of the organization. This allows them to make the best decision on the ability of the organization to make a profit.
It can also be used by management to decide which expense can be cut to allow the profit margins to be higher. 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.
What is an Income Statement?
The financial statement shows the organization's performance in terms of the money they are receiving for their key business dealings (revenue), as well as the money they are spending 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 the business and are not going to be happening 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, they also add the statement of comprehensive income, which includes any changes in equity as well as certain gains that have not yet been realized.
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.
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The Income statement is divided into a few key components. These components are
This area shows the money that has been received. It is the money received directly by the organization's day-to-day business dealings. For example, the payment they receive 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.
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.
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.
These are more of the indirect expenses used to make the revenue. Examples are wages, rent, and advertisement expenses.
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.
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.
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 the revenues are less than the expenses, this means that there is a net loss. Therefore, representing 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:
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 look at the statement to analyze the organization's ability to repay the loan. If they see that the organization is making consistent profits, then they may decide to give them the loan; however, if they are not making profits consistently, they will not.
There are many ways the organization can benchmark its statement. The first is benchmarking against industry standards. This 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 will be compared to the organization's direct competitors and will show 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.
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 cased.
Having the gross profit, profit before tax and net profit shows how the organization is performing on multiple levels. First, it shows how the revenue lines up with direct expenses, then indirect expenses, and finally against the taxes.
Putting the expenses also shows the biggest threats to profitability, and they can be made into percentages to see their weighting.
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 there is a steady stream of revenue entering the organization and that the profit margins are high enough to be able to pay back the loan as well as the interest.
Users of the statement
There are many different uses of the statement, and each user of the statement has various reasons as to why they are using it. Although all the users of the statements have common indicators, they all look for when analyzing the 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: They are the members who have a financial interest in the performance of the organization. They use it to analyze the share price of the organization and if they should 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 each use it differently. These might be like government, lobby groups, employees, etc.
Benefits of the 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 has the most important information that affects the share price. The statement can be used by the investors to determine if the organization's share price is correct or if there is a way to make a profit.
The ratios that can be used to analyze the financial statement are the gross margin and the profit margin. These ratios examine the financial health of the organization and can be used to benchmark to determine if the organization is performing effectively and efficiently.
- 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 vs. the actual, and as time goes on, they will become better at forecasting the performance in future reporting periods. It also allows the organization to better prepare for some poor performances and understands the reasons.
- It is a tool for better decision making
The profit and loss statement is a way for an organization to make better decisions as it allows the organization to gain more information about the organization's performance. They can see what allows them to make more money and any costly areas that are decreasing their profitability.
Using profitability ratios like gross margin and profit margin allows an organization to make decisions on the expenses they are incurring and ways to decrease them to increase the ratios.
Limitation of the Statement
Although it has a lot of benefits, it also has some limitations that can negatively affect the organization.
The limitations are:
- 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 for the expenses to be less, therefore, increasing the profits. These tactics are very misleading and may lead the reader to believe that the organization is performing better than they are.
- 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, they 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 negatively
In some cases, the statement can work against the organization. For example, in cases where the organization is making bigger profit margins, it leads to more users analyzing their 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 takes financial aspects into account may lead to the organization making some bad choices to decrease the expenses that may lead them to more problems down the line.
An example is if the organization has a process of production that is expensive and socially and ethically responsible. They may decide to forego that process and choose the cheaper and socially irresponsible options, which may lead to lawsuits or boycotts in the future.
Everything You Need To Master Financial Statement Modeling
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Researched and authored by Abdulrahman Nur | LinkedIn
Reviewed and Edited by Savan Sabu | LinkedIn
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