Income statements are one of the three important financial statements used for reporting a company’s financial performance over a specific accounting period, with the other two key statements being the balance sheet and the statement of cash flows.
Also known as the profit and loss statement or the statement of revenue and expense, the income statement primarily focuses on company’s revenues and expenses during a particular period.
Income statements are an important part of the company’s performance reports that must be submitted to the Securities and Exchange Commission (SEC). While a balance sheet provides the snapshot of company’s financials as of a particular date, the income statement reports income through a particular time period and its heading indicates the duration which may read as for the (fiscal) year/quarter ended September 30, 2018.
Income statements focus on the four key items – revenue, expenses, gains and losses. It does not cover receipts (money received by the business) or the cash payments/disbursements (money paid by the business). It starts with the details of sales, and then works down to compute the net income and eventually the earnings per share (EPS). Essentially, it gives an account of how the net revenue realized by the company gets transformed into net earnings (profit or loss).
Revenues and Gains
– Operating Revenue
Revenue realized through primary activities is often referred to as operating revenue. For a company manufacturing a product, or for a wholesaler, distributor or retailer involved in the business of selling that product, the revenue from primary activities refers to revenue achieved from sale of the product. Similarly, for a company (or its franchisees) in the business of offering services, revenue from primary activities refers to the revenue or fees earned in exchange of offering those services.
– Non-operating Revenue
Revenues realized through secondary, non-core business activities are often referred to as non-operating recurring revenues. These revenues are sourced from the earnings which are outside of purchase and sale of goods and services, and may include income from interest earned on business capital lying in the bank, rental income from business property, income from strategic partnerships like royalty payment receipts or income from an advertisement display placed on business property.
Also called as other income, gains indicate the net money made from other activities, like sale of long-term assets. These include the net income realized from one-time non-business activities, like a company selling its old transportation van, unused land, or a subsidiary company.
Revenue should not be confused with receipts. Revenue is usually accounted for in the period when sales are made or services are delivered. Receipts are the cash received, and are accounted for when the money is actually received. For instance, a customer may take goods/services from a company on 28 September which will lead to the revenue being accounted for in the month of September. Owing to his good reputation, the customer may be given a 30-day payment window. It will give him time till 28 October to make the payment which is when the receipts are accounted for.
Expenses and Losses
Expenses linked to primary activities: All expenses incurred for earning the normal operating revenue linked to the primary activity of the business. They include cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortization, and research and development (R&D) expenses. Typical items that make up the list are employee wages, sales commissions, and expenses for utilities like electricity and transportation.
Expenses linked to secondary activities: All expenses linked to non-core business activities, like interest paid on loan money.
All expenses that go towards loss-making sale of long-term assets, one-time or any other unusual costs, or expenses towards lawsuits.
While primary revenue and expenses offer insights into how well the company’s core business is performing, the secondary revenue and expenses account for the company’s involvement and its expertise in managing the ad-hoc, non-core activities. Compared to the income from sale of manufactured goods, a substantially high interest income from money lying in the bank indicates that the business may not be utilizing the available cash to its full potential by expanding the production capacity, or it is facing challenges in increasing its market share amid competition.
Net Income is calculated based on the following:
Net Income = (Revenue + Gains) – (Expenses + Losses)
Real-world companies often operate on a global scale, have diversified business segments offering mix of products and services, and frequently get involve in mergers, acquisitions and strategic partnerships. Such wide array of operations, diversified set of expenses, various business activities, and the need for reporting in a standard format as per regulatory compliance leads to multiple and complex accounting entries in the income statement.
Listed companies follow the Multiple-Step Income Statement which segregates the operating revenues, operating expenses and gains from the non-operating revenues, non-operating expenses, and losses, and offer many more details through the income statement. Essentially, the different measures of profitability in a multiple-step income statement are reported at four different levels in a business’ operations – gross, operating, pre-tax and after-tax. As we shall shortly see in the following example, this segregation helps in identifying how the income and profitability is moving/changing from one level to the other.
For instance, high gross profit but lower operating income indicates higher expenses, while higher pre-tax profit and lower post-tax profit indicates loss of earnings to taxes and other one-time, unusual expenses.
Uses of Income Statements
Though the main purpose of income statements is to convey details of profitability and business activities of the company to the stakeholders, it also provides detailed insights into the company’s internals for comparison across different businesses and sectors. Such statements are also prepared more frequently at department- and segment-levels to gain deeper insights by the company management for checking the progress of various operations all throughout the year, though such interim reports may remain internal to the company.
Based on income statements, management can take decisions like expanding to new geographies, pushing sales, increasing production capacity, increased utilization or outright sale of assets, or shutting down a department or product line.
Competitors may also use them to gain insights about the success parameters of a company and focus areas, like increasing R&D spends.
Creditors may find limited use of income statements as they are more concerned about company’s future cash flows, instead of its past profitability.
Research analysts use the income statement to compare year-on-year and quarter-on-quarter performance. One can infer whether company’s efforts in reducing the cost of sales helped it improve profits over time, or whether the management managed to keep a tab on operating expenses without compromising on profitability.
An income statement provides valuable insights into various aspect of a business. They include company’s operations, the efficiency of its management, the possible leaky areas that may be eroding profits, and whether company is performing in line with industry peers.
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