The income statement records the income and expenses of a business over a period of time. It gives us the financial results of business activity - how successful the operation of the business is. If income exceeds expenses during the period measured, there is a net profit. If expenses exceed income, there is a net loss. The operations recorded in the income statement flow through to the balance sheet. Generally, the income statement is an important analytical tool for understanding the operations of the business.
A rule of business is, "It takes money to make money." Typically, producing goods for sale is the greatest cost of generating revenue. For example, a computer manufacturing company must buy wiring and other raw materials to make computers; pay wages to workers and managers; and spend money on overhead - power, facilities, and maintenance. A company deducts these costs (cost of sales, cost of goods sold) from revenue or sales, showing gross profit (or loss).
Revenue or Sales (turnover - UK)
Companies earn revenue (turnover) in one or more of the following ways:
- by selling products or services, or both
- by leasing and renting equipment or property to others
- by receiving interest from loans to other companies or individuals
Revenue is the total amount of funds generated by the business from product and/or services delivered to customers during the income statement period. Sales are recorded when made, not when the sold product or service is actually paid for.
Some companies have only one source of revenue; others have several. For example, HP reports revenue from its products, such as computer hardware and software. It also reports revenue from its services, which include maintenance,outsourcing, consulting and financing.
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Cost of
Goods Sold or Cost of Sales
The cost of goods sold is the amount it costs to produce or
procure the products sold during the income statement period.
This figure can also include additional items such as downward
adjustments of inventory (not sold) at the end of the period
to recognize the loss of value of inventory that has become
obsolete, was damaged or was stolen. Cost of Goods Sold is subtracted
from Revenue or Sales to equal Gross Profit or Gross Income. |
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Gross Profit or Gross
Income (or loss)
Gross
Profit or Gross Income is the income from sales or revenue after
deducting the cost of goods sold. As the first measure of income
in the income statement, it is important because it tells us
what kind of markup (in relation to sales) the business is able
to obtain on its cost of goods sold. |
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Operating Expenses
Operating expenses are the expenses
that are incurred by the business during the income statement
period, that are not directly linked to the cost of making a
product, but that are a cost of day-to-day operations. Examples
are administrative and management salaries (but not labor),
rent, utility costs, advertising, insurance, office supplies,
commissions to sales, research and development, etc. A business
deducts these operating expenses from gross profit, resulting
in operating income (or loss). |
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Operating Income
Operating income is the income that
remains after cost of goods sold and operating expenses are
deducted from sales or revenue. It represents a company's revenue
minus all expenses required
to obtain that revenue. Operating income is derived by subtracting
operating expenses from gross profit or gross income. It is
an important measure of the success of the company because it
represents the earnings ability of the business as a result
of doing what it was formed to do, instead of making profits
through its investments or other non operating activities.
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Interest Expense
Interest expense is the amount
charged for the use of borrowed funds during the income statement
perioid. It includes interest on all loans, both short- and
long term and any other financial costs related to borrowing
such as loan fees. |
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Income Tax Expense
Income tax expense is the tax
payable to the government on the business's taxable income to
include operating income and non-operating income such as income
on investments or the sale of property, etc. |
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Net Income (loss)
or Net Earnings
Net
earnings are the magical "bottom line" (often literally the
last line on the statement). After a company deducts all costs
and expenses from revenue. When revenue exceeds costs and expenses,
the bottom line shows a profit. When costs and expenses exceed
revenue, the bottom line shows a loss.
The
net income can be used for one of three uses:
- It can be retained by the company (in which
case it will flow through to the retained earnings account
on the balance sheet).
- It may be distributed all or in part to
shareholders as their share of the firm's profits for the
period covered by the income statement (in which case it
benefits the shareholders but not the future operations
of the company). Those payments are called dividends.
It can be used to buy growth in net earnings and that usually
signals that a company is doing well.
Earnings per share (EPS) shows how much money
Shareholders would receive for each share of stock
if the company distributed all net earnings to its Shareholders.
Although all net earnings really belong to the Shareholders,
a company almost never distributes the full amount to them
directly. A company needs money to grow, so it takes part
of the net earnings and reinvests that money in itself. The
total amount of a company's net earnings since its inception,
minus any payments made to Shareholders, is called retained
earnings.
Although the term may suggest a large pool
of cash, that image is misleading. Retained earnings is actually
part of Shareholders' equity and represents the portion of
a company's assets that is financed from profitable operations
rather than from selling stock to investors or borrowing from
external sources. If the company reinvests those earnings
profitably, the Shareholders benefit from that reinvestment
over the long term.
A second way Shareholders benefit from retained
earnings is through dividends. A company's board of directors,
with the advice of management, decides on the amount of dividends
per share to pay. Companies usually pay dividends quarterly;
however, many companies don't pay dividends at all, and a
few pay dividends irregularly. |
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