Income Statement
An income statement is an essential financial statement employed in order to report a firm's financial performance for a given accounting interval. Besides this report, a statement of cash flow and the balance sheet are also common in accounting. The income statement concentrates on the firm’s revenue and expenses over a certain period of time. The ability to conduct a competent analysis of the income statement allows the investor to make the best decisions regarding investing in a particular company.
The basics of Income Statements
An income statement analyzes different aspects of a company's business. The income statement allows the company's management to review the completed operations, take up the issue of business management efficiency, assess possible weaknesses that reduce profits, and understand whether the company is able to compete with industry peers.
The difference between balance sheets and income statements is that the former presents the financial performance of a firm on a specific date rather than a certain period of time. Since the income statement is a significant report of a company's performance, it must be presented to the Securities and Exchange Commission (SEC).
The heading of the income statement indicates the length of the period that is taken into account, such as a quarter or a year. Revenue, expenses, gains and losses are four main elements that form the income statement basis. This statement reflects sales/purchases for cash and on credit. In fact, the income statement reports how the net revenue gained by the firm gets converted into net earnings (profits or losses).
Income Statement’s sections
Local regulatory requirements, the scale and direction of the business, and the specific operating activities may affect the content of the income statement, however, the main sections of the financial statement are identical everywhere.
Revenue. Revenue earned from core company’s activities is considered operating revenue. If an entity manufactures an item, or sells and distributes it, operating revenue equals the revenue from the product’s sale. For a company providing services, the situation works exactly the same. Operating revenue relates to the revenue received for the provision of services.
As for revenue earned from secondary business activities, it is typically considered non-operating recurring revenue. It is not related to purchasing or selling of goods and services but includes interest income, commercial property rental income, advertising income and others.
It is necessary to distinguish between the two terms "revenue" and "receipts". Revenue is typically recorded over the period of making purchases and providing services. Receipts are the received funds, accounted for at the time of their actual arrival. As an example, goods from a firm may be received by a customer on Oct. 30, so revenue will be accounted for in October. If the customer is in good standing, he can get a payment window of 30 days. Revenue is shown in the income statement, while receipts are not.
Gains. Gains, also known as other income, signal the net money earned from other activities, for example, through long term assets' sale. At its core, this is the net income that the company receives from one-time non-commercial activities.
Expenses. The costs of keeping the business running and making a profit are called expenses. Some expenses can be written down on a tax return when meeting the Internal Revenue Service requirements. All expenses which were necessary in order to earn the normal operating revenue connected with the main business’s activity are known as primary-activity expenses. Cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortization, and research and development (R&D) expenses are part of the primary-activity expenses. Other examples of expenses are wages, commissions for sales, and expenses for utilities. Expenses connected with non-main activities of business, for example, interest paid on loan, are named secondary-activity expenses.
Losses. These are expenses from unprofitably sold long term assets, non-recurring and other unusual expenses or costs of litigation.
Primary revenue and expenses demonstrate how well a firm's primary business is doing. Secondary income and expenses evaluate the company's managerial experience with special, non-profile activities.
Real example of the Income Statement
To get the value of net income, the following formula can be applied:
Assume a sports nutrition company that provides training as an additional service reports earnings for the most recent quarter. The firm received $20,000 selling sports nutrition and $3,000 providing training courses services, and it spent $10,000 on these activities. The company's net gains of $1,000 came from the sale of an old van. At the same time, the firm lost $900 in legal costs incurred to resolve a dispute with a client. As a result, for this quarter, a net income is $13,100.
The above is a simplified form of income statement that applies to any business. This income statement is considered the Single-Step Income Statement because it involves an elementary calculation. Nevertheless, in reality, the global scale of the business implies the presence of diversified segments, through offering a range of products and services, and frequently engaging in mergers, acquisitions and strategic partnerships. The extended range of operations, diversified expenses, different company’s activities and the requirement to report in standard form lead to complex income statement entries.
For companies traded on the stock exchange, the Multiple-Step Income Statement is provided. This type of report separates operating revenue and expenses, gains from non-operating revenue, non-operating expenses and losses. In addition, the income statement drawn up in this way contains more details. There are four stages of operations that reflect various profitability measures in this type of income statement: gross, operating, pre- and post-tax. This separation gives an understanding of how income and profitability move between levels.
Thus, a high gross profit with lower operating income signals higher expenses. A higher pre-tax profit and a lower after-tax profit signal lost profits due to taxes and unusual expenses.
How to use Income Statements
In addition to the income statement’s primary aim, which is to provide interested parties with information about the business activities and profitability of the company, there is another point. The income statement gives many details that allow evaluating the internal activities of the company and analyze it in comparison with similar companies in the sector.
Analyzing sections of the income statement and expenses, the investor understands what exactly makes a company profitable. The income statement is the basis for management's decisions to open outlets in new regions and increase production capacity in order to boost sales. In addition, issues such as the sale of assets or the removal of goods from sales, and the closure of unprofitable branches of the company may be raised.
Information from the income statement can also be used by competitors to assess the strengths and weaknesses of a company in a similar sector. To lenders, income statements may seem limited because they do not provide information about the future cash flows of the company, which is more important to them than the profitability of the company in the past.
Income statements can be useful to research analysts in order to correlate year-over-year (YOY) and quarter on quarter (QOQ) results of the company. An assessment can be made to understand whether the company's efforts to reduce cost of sales and increase profits over time have been effective.
How to read typical Income Statements
In the example below, the annual income statement for 2021 of two corporations, but related to different sectors of the economy, is proposed for consideration. They are Microsoft in the technology sector and Walmart in the retail sector.
Revenue section. The “Revenue” section lists the Gross (Annual) Profit of Microsoft of $115.86 billion (based on taxable year ending 06/30/2021). The cost of revenue of $52.23 billion was deducted from total revenue for the fiscal year under review of $168.09 billion. Thus, this figure was obtained.
In 2021, Walmart generated costs for revenue of $572.75 billion, accounting for 75% of the company's total sales, while Microsoft spent 30% this fiscal year, or $429 billion. This implies that Walmart's costs were higher than Microsoft's while generating identical sales.
Operating expenses. In this section, we will use Microsoft's cost of revenue and total revenue for the fiscal year. Microsoft's total operating expenses are calculated by adding the three numbers together = (cost of revenue of $52.23 billion + research and development (R&D) of $20.72 billion + Selling General and Administrative Expense (SG&A)$25.23 billion) = $98.18 billion.
The reduction in the total operating expenses from total revenue resulted in the operating income = ($168.09 billion - $98.18 billion) = $69.92 billion. The measure displays the Earnings Before Interest and Taxes (EBIT) for its primary activity, and is used to generate the net income. Walmart did not spend funds on R&D, and had higher SG&A and total operating expenses than Microsoft.
Income from continuing operations. This section considers other net income or expenses, interest expenses, and related taxes. Microsoft’s Net Income From Continuing Operations is $61.27 billion, which is about 60% higher than Walmart’s figure of $13.67 billion.
By discounting one-time events, an investor can calculate the value of net income suitable for ordinary shares. Walmart's net income is well below Microsoft’s ($13.67 billion vs. $61.27 billion).
By dividing the net income by the number of weighted average shares outstanding, an investor can get earnings per share (EPS). Microsoft’s EPS is $8.12 per share, while Walmart's is $4.90.
