Investing in stocks requires understanding the companies you’re interested in. And investors should become familiar with three particular financial statements that can reveal a lot about each company’s financial health: the income statement, the balance sheet, and the cash flow statement.
The income statement is particularly important to investors because it allows for the analysis of how profitable a company is and how robustly it’s likely to grow in the future. How well a company is doing and how well it’s likely to do in coming years are major indicators of whether a company is a good investment.
If you’re a business owner, creating an income statement is an essential part of managing your financial affairs. You are unlikely to be able to do much—from getting a loan to selling your company—without knowing how to create an income statement.
Whether you’re an investor or an entrepreneur, read on to learn more about the ins and outs of income statements, and why you should become familiar with these all-important sets of numbers.
What is an income statement?
The income statement, otherwise known as a profit and loss statement (P&L), is one of the basic methods that businesses use to track and report their revenue, expenses, and net income or loss over a given interval. This statement is a summary of a company’s performance during that time, which can range from a few weeks to a fiscal year.
An income statement is important because it shows how profitable the company was during a given time period. It shows past performance, can be used to extrapolate future performance, and predicts the business’s ability to generate cashflow.
As such, an income statement can be used for any purpose in which reporting on the profitability of a company is important, such as reviewing business practices and performance, getting credit from a lender, selling the business, comparing the business with competitors, or working with government agencies, labor unions, or other partners.
[FEATURED SNIPPET: An income statement calculates a business’s revenue, expenses, and net income during a particular period time, and is an indication of a company’s performance during that interval.]
Income statement format
An income statement is comprised of revenue, expenses, and a calculation of net income or loss. These three elements together combine to showcase for management and investors whether the firm made a profit during the identified time period.
Here are some more details about the features of every income statement:
Revenue
Revenue is money earned from the sale of products and/or services. This income is listed before expenses are subtracted, and is also called “top line” revenue. Revenue will also encompass other sources of earnings, such as commissions and rent payments.
Expenses
Expenses are cash outflows or other methods of using up assets or gaining liabilities. Expenses include such things as outlays for materials and labor, depreciation, taxes, and research and development expenses.
Net income or loss
Net income, also called the “bottom line,” is the amount of income that remains after all expenses have been subtracted from the top-line revenue. If the amount of revenue is more than the amount of expenses, then this will be net income. If the amount of revenue is less than the amount of expenses, then this will be a net loss (otherwise known as being “in the red” due to the red ink often used to indicate a loss).
The net income or loss is a key number for investors, since it can be used to calculate how much profit (or loss) shareholders will see for that period. Investors who are considering a certain stock will want to ensure that the company in question has been earning income in recent periods, preferably a robust income. At the very least, investors should know how to avoid potential stock purchases from companies that are operating at a loss.
Income statement example and sample
To provide a simple idea of what an income statement may look like, imagine a fictitious company called Tanya’s T-shirts. Entrepreneur Tanya creates whimsical illustrations that she gets screen-printed on t-shirts, which she sells to consumers via her website.
The revenue she receives is from the sales of her shirts, as well as some commissions for selling some goods for other companies on her site. Her expenses consist of the costs of buying the blank t-shirts and paying for the screen-printing, paying salaries to herself and two employees, advertising her wares online, renting and lighting the workspace where she handles design and shipping, business insurance, equipment, the depreciation of that equipment, and business taxes.
Here is how a simple income statement for Tanya’s business might look. She’s doing pretty well at the end of the year, with a net income of almost $400,000.
How to prepare an income statement
An income statement can be very straightforward or can be complicated, depending on what style of statement you’re preparing (see next section). To prepare a simple income statement, follow these steps.
Decide on your time period. Which interval you choose depends on the purpose of the statement and the information you need to know or to share. Decide this first so that you know which numbers you need to collect.
Get a handle on all your numbers. Carefully collect the info you need about your revenue and expenses. You must know exactly how much revenue you generate from all sources, as well as your total expenses for each line item.
Decide how you will portray your costs. The question is whether you will use absorption costing or variable costing. Absorption costing includes all the costs related to production that don’t change no matter how much or little you produce, such as workers’ salaries and rent for the production space. Variable costing accounts only for the costs directly related to production that rise and fall depending on how much of the item you make, such as the cost of materials. If you use variable costing, you’ll separate fixed-cost operating expenses from production costs in the income statement.
Lay out all your revenues and expenses in a table. Remember to put fixed operating expenses in a. separate section if you’re using variable costing. If you’re using absorption costing, you can list all of the expenses together, like Tanya does above.
Calculate your net income or loss. Add up all the lines in the table to get your final result—your net income or loss. Put this at the bottom of the table.
Styles of income statements
There are various ways of laying out an income statement, from simple to complex. Which one you choose depends on the complexity of your business, how you choose to analyze your business, what your investors or management want to see, and your comfort with these types of calculations. Here are various types of income statements.
Common size income statement:This type of income statement shows the value of each line item as a percentage of the value of revenue or sales. This shows what percentage of your revenue each expense accounts for.
Single-step income statement:The single-step income statement is the simplest kind. It is what Tanya created above–a statement in which all the business’s expenses are listed together and totaled up, instead of being broken out into categories.
Multi-step income statement: The multi-step income divides things up a bit more. These statements have different categories for operating revenues and operating expenses, non-operating revenues, non-operating expenses, gains, and losses. This type of statement includes a line for gross profit, which is the net sales minus the cost of goods sold.
Pro forma income statement: A pro forma income statement is one that looks into the future to predict net income or gain. The word is sometimes also used to indicate an income statement that tweaks things to see how a theoretical change would have affected the company’s fortunes. For example, a pro forma income statement may be one that looks at how the company would have performed if it had dropped a particularly disappointing product at a given time.
Contribution margin income statement:This type of income statement subtracts all variable expenses from sales, resulting in a “contribution margin.” All fixed expenses are then taken out of the contribution margin to result in the net profit or loss for the given period. This method of categorizing the income statement is effective because the contribution margin indicates clearly how much money is available to cover fixed costs, and thus how much in sales will be needed to generate a profit.
Balance sheet vs. income statement
An income statement and a balance sheet are very similar, but differ greatly in what information they provide about the business. Where an income statement is a record of the revenue and expenses of the company over a set period of time, the balance sheet is a snapshot of the assets and liabilities of company at a single point in time. The balance sheet, which is usually more detailed than an income statement, is used to assess the current health of a company in order to inform financial decisions.
An income statement, on the other hand, provides details about how the revenue and expenses in a business play out over time, which reveals whether the company is operating with income or at a loss during a particular period. The income statement is an essential tool for every business and an important source of information for every investor.
