A company’s income statement serves as its report card. It reveals the important parts of any organization that you can’t immediately see on the surface.

This comprehensive guide to income statements will provide everything you need to know about a company’s sales activity, its cost of producing or buying, and its expenses. The income statement reflects the financial activities of the business during a specific accounting period, which can be monthly, quarterly, annually, or some other finite period of time.

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In a nutshell, it’s what comes in, what goes out, and what’s left over at the end. It’s also usually the first document in an annual report or financial filing.

As a seller, understanding a company’s financial health will enable you to build a business case for the product or service you’re selling.

In order to effectively lead customers to mutually beneficial decisions, you must be able to understand and master financial metrics. Rather than offering vague suggestions about how much money your company can save the prospect, you’ll have definite figures to support your claims.

If a company’s stock is publicly traded, it's legally required to file financial disclosures with the Securities and Exchange Commission. The SEC’s search feature will allow you to search for companies and their financial filings and will also allow you to request updates on new filings.

What is an income statement?

The income statement records a company’s profitability and tells you how much money a corporation made or lost. The income statement reports earnings over time so interested parties can evaluate how the company is performing over a specific period.

Typically, an income statement reflects three accounting periods: the current one plus two previous ones. The span of three periods allows users to assess the business’ earning trends over time.

A balance sheet reports a company's assets, liabilities, and equity to determine if it has enough liquidity to cover its financial obligations. It's a snapshot of the business' financial standing at a single point in time.

And the income statement takes a look at revenue and expenses over an accounting period, which is typically 12 months. It reports the company's net income or loss for that period. The primary use of the income statement is to determine if the business has enough profit to pay its liabilities.

Income Statement Format

There are two types of income statements: single-step and multi-step income statements. No matter which type you're creating, the income statement includes five key components.

  1. Sales or revenue: Total amount earned by selling the business’ products or services. It’s the total of all the sales or revenue accounts. The top line of the report may use the terms sales or revenues interchangeably. Either is acceptable.
  2. Cost of goods sold: Total amount spent to buy or make the products or goods that were sold during the specified period of time.
  3. Gross profit: Amount of money a business earned before operating costs, figured by subtracting the cost of goods sold from sales or revenue.
  4. Operating expenses: Amount of money spent on operating costs such as salaries, administrative fees, utilities, and advertising.
  5. Net income or loss: Whether the company made a profit or a loss during the specified period, figured by subtracting total expense from gross profit.

Also known as the “profit and loss statement,” income statements often include many subcategories and, as a result, many more line items. Even so, the document boils down to income, expenses, and the difference between the two.

Income Statement Example

Income is always listed before expenses, and the company’s bottom line is exactly that: it’s the last line of the document. Let's take a look at an income statement, or statement of operations, from Amazon.

Source: SEC

Here are some things to note when reading an income statement:

  • The report likely won’t include minus signs to indicate deductions, though it may use parentheses to signal them.
  • The final profit will have a double-underline so you can easily spot it, but it may be called earnings, income, surplus, or net income instead of profit.
  • You won’t be able to tell how many unique sales were made; only how many different customers purchased from the company and how the sales were distributed over a specific period of time.
  • Revenue gets counted when the goods are delivered, not when the customer pays for them.
  • If the bottom line is a negative number, then the company suffered a loss over the time period in question.

An income statement can be prepared on a monthly, quarterly or annual basis. Before you can prepare an income statement, you'll need to determine how much revenue your business generated, and the expenses it incurred over the selected accounting period.

While there are often many line items in the income statement, it can be summarized with the following formula:

Revenues - Expenses = Net Income

Understanding the Income Statement

If you’re tasked with reviewing an income statement, begin by checking the math.

The only math skills you need are addition and subtraction to verify that the numbers are calculated accurately. Whether you find an error or not, adding and subtracting the values will help you increase your understanding of how the entries fit together.

1. Find the bottom line.

First, find the company’s bottom line. A positive number means that the company earned more than it spent and it has the resources necessary to pay its employees and its bills. (The company is considered “in the black.”)

If the bottom line has a negative in front of it, is printed in red, or is enclosed in parentheses, then the company spent more than it earned, and it’s important to understand why. (The company is considered “in the red.”)

A net loss isn’t always catastrophic, especially in the case of start-up companies which have higher expenses without profit in the first couple of years. Likewise, cyclical businesses like agriculture have different yields each year and should expect to see up and down years.

The key is to watch for trends that suggest the company doesn’t have enough cash to fund its expenses.

2. Identify income.

Revenue is generally the simplest part of the statement because there is a single number that reflects all the money a company earned. Increasing revenue is often the fastest way to improve profitability.

Check to see that the income makes sense for the business in question. Watch for one-time gifts that aren’t sustainable because they aren’t guaranteed to repeat.

Then, look for one-off income sources that may not repeat, such as special events that don’t occur every year. Continuous, predictable revenues are the most desirable.

3. Evaluate expenses.

Expenses will typically include salaries, wages, rent, insurance, interest, and supplies.

The largest expenditures vary based on the business type: for service businesses, salaries will be the largest, but for manufacturing, supplies and materials are the largest.

Look for illogical items. In a company with very few employees, are the salary expenditures unexpectedly high? This is something to keep an eye on.

4. Look for trends.

Since income statements typically include three reporting periods, watch for performance over the course of those three periods.

If the document doesn’t reflect the percentage change in each category, calculate it by figuring out the difference between the two figures in question, and then dividing that number by the original number. Multiply your answer by 100. If the answer is negative, the change represents a loss.

Think logically about the numbers reported on the statement, and seek explanations for things that don’t make sense. In some cases, there will be logical explanations. In other cases, discrepancies may exist.

Consider that when Lehman Brothers filed for bankruptcy in 2008, the company had $639 billion in assets, and its income statement made the company appear profitable.

5. Draw conclusions.

When a company’s revenues well outpace its expenses, that company can be said to have a high-profit margin. High-profit margins indicate that the company is controlling its costs well or that its revenues are growing faster than its expenses.

These companies typically have an advantage over their competitors because they have a better cushion during downturns, and they often have the resources to improve their market share during hard times, emerging even stronger afterward.

6. Understand the metrics.

Sales reps must be able to demonstrate the business value of a product or service to the decision-makers within a company. You must demonstrate the return on investment you can provide in order to convince them to buy.

Sales professionals who don’t understand finances will find it difficult to sell effectively because they don’t understand the financial benefits of their product or service. They’ll find it difficult to negotiate without the ability to understand concepts such as ROI, capital expenditures, or operating expenses.

B2B selling in particular demands that salespeople demonstrate quantifiable savings in time, effort, or money for the prospect. Sellers who can’t adequately understand how companies operate their finances will struggle to demonstrate financial value to their customers.

7. Solve problems.

Understanding your prospects’ net worth and liabilities can help you qualify your prospects and determine whether they have the budget to afford what you’re offering.

Your ability to understand your prospects’ financial situation will help you speak to them in relevant terms and prove your product’s worth. And to learn more about financial statements, check out this breakdown of earnings before interest, taxes, depreciation, and amortization (EBITDA) next.

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Originally published Feb 22, 2019 8:35:00 AM, updated February 22 2019

Topics:

Accounting