The income statement conveys a wealth of information that is commonly used in the analysis of a business. It is one of the three core financial statements, that include the balance sheet, income statement, and statement of cash flows. While analysts turn to all three to get a comprehensive idea of the financial health and quality of income a business has, the income statement is often viewed on its own due to the vast amount of information it can communicate.
Understanding what the income statement is and the various components that make up the income statement will help you understand why it is so important. In this FAQ we will discuss all of that and provide a framework for building an income statement as well.
What Is The Income Statement?
An income statement contains information for a specific period of time on the revenues and expenses of a business. It is sometimes referred to as the profit and loss statement or the statement of operations. The income statement reflects the net income of a business along with all forms of revenues, gains, expenses, and losses.
Depending on the accounting policy of the reporting entity, the income statement might represent income and expenses that are not yet received or paid in cash. This approach is referred to as accrual accounting under US GAAP and it is the required method of reporting for publicly traded companies. Other options include cash basis or tax basis
Under US GAAP businesses that report using the accrual method of accounting report income and expenses in the period they are incurred. This is why analysts often rely on the balance sheet and the statement of cash flows to help paint the entire financial landscape of the company.
Why Is The Income Statement Important?
The income statement shows all income and expenses of a business, including those unrelated to its core business model. For example, it will reflect gain/loss on the sale of investments, gain/loss on foreign currency exchange, and gain/loss due to extraordinary events.
Another critical aspect of the income statement is that it reflects interest expense. This helps analysts to determine the cost of financing and how it might be impacting the bottom line. While the bottom line (net income) is often discussed in the context of CPA, analysts often turn to another metric to determine the quality of a business’s earnings.
Because non-cash items are on the income statement and financing costs are also reflected, analysts turn to a metric referred to as EBITDA. EBITDA reflects earnings before interest, taxes, depreciation, and amortization.
Even though these items are excluded from EBITDA, it is still considered to be the most reflective measure of corporate performance. This is because EBITDA is considered to be a pure measure of profitability.
By excluding taxes, non-cash expenses, and the cost of financing, EBITDA is able to communicate how much actual profit a business is capable of.
The Components Of The Income Statement
The income statement walks through gross profit, adds in fixed costs, interest, depreciation, amortization, taxes to arrive at net income. Income statements are unusually accompanied by important information containing the footnotes of the financial statements.
Below are the components of the income statement:
Gross profit is all revenue less the cost of goods sold and other direct production costs. It is the first section of the income statement.
Once gross profit is calculated, then it is reduced by selling, general, and administrative expenses(SG&A). The result of reducing gross profit by these operating expenses is sometimes referred to as operating profit.
Other Operating And Non-Cash Expenses
Once operating profit is calculated, it is reduced by depreciation and amortization. Depreciation is the practice of expensing fixed assets owned by the business over a specific period of time. Amortization is the practice of calculating an intangible asset’s useful life and expensing those costs over a specific period of time. Because expenses should be reported in the period they are incurred, the cost basis of intangible assets and the cost of utilizing other assets is spread out over the expected life of the assets, in effect expensing them in the periods they should be.
Once operating profit is reduced by non-cash expenses, it is then increased or decreased by interest income or expenses.
Income Before Taxes
The result of reducing gross profit by SG&A, depreciation and amortization, and interest expenses is often calculated separately and represented as “income before taxes” or EBT.
Once EBT is calculated it is reduced by the amount of tax expense, or expected tax expense, for the period.
The result of reducing EBT by tax expense is called net income, or “the bottom line”, Net income is considered to be the final amount of income for the period, although analysts typically rely on EBITDA more heavily.
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