Previously, we discussed analyzing the balance sheet. Let’s continue the series, Fundamentals of Analyzing Financial Statements, by exploring the income statement. As a business owner, your main financial goal is to make a profit. Profit can be evaluated and analyzed by utilizing the Income Statement.
An income statement, also known as the profit and loss statement, consists of income and expenses of a business during a period of time. It includes a cumulative amount of revenue, gain, expense, and loss transactions. Gross Income is all money earned from sales of products and/or services. Net income is money earned after expenses and deductions. Cost of goods sold (COGS) and selling, administrative, and general (SGA) expenses are typically the main expense accounts. Expenses can be classified as a fixed expense or a variable expense. Fixed expenses are those charges that remain the same from period-to-period, whereas variable expenses change based on output.
Operating income and expenses entails transactions that are derived from primary business activities. On the other hand, non-operating income and expenses include activities that are not involved in the day-to-day business transactions. Gains and losses are non-operating line items that are generated based on non-operating activities, such as the sale of a long-term asset.
Revenue – COGS = Gross Profit
Gross Profit – Operating Expenses = Operating Income
Operating Income – Non-Operating Expenses = Income before taxes
Income before taxes – Taxes = Net Income
The income statement provides useful insight into a company’s operations and financial performance. Line items of the income statement can be evaluated in several ways.
1. Vertical analysis: main income statement line items are stated in percentages of gross sales.
2. Horizontal analysis: analyzes the changes in the dollar amounts in a financial statement over various reporting periods.
3. Gross profit margin: expressed as a percentage of sales. The higher the result, the better. It indicates the amount of profit over the cost of goods sold. Formula: Gross Profit/Revenue x 100
4. Net profit margin: calculates the net profit as a percentage of revenue. It indicates how revenue translates to profit because an increase in revenue does not always increase profit. Formula: Net Income/Revenue x 100
Various other analyses can be used to analyze the income statement in a comparative format. The income statement is important for a financial team, management, and investors to understand how a business is performing and financially.