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Income Statement Basics
The Income Statement provides an overview of how a company has performed over a given period of time. It indicates how revenue is transformed into net income and provides important insights into how effectively the management is controlling expenses. Format and Elements of an Income Statement While the following section describes the common elements of an income statement, the format of the income statement will vary according to the complexity of business activities. Format of an Income Statement Years ended December 31 20X8 20×9 Revenue/Net Sales Cost of Sales Gross margin Operating expenses: Depreciation and amortization Selling, general and administrative expenses Operating income: Other income (expense): Dividend and interest income Interest expense Income before income taxes and extraordinary loss Income taxes Income before extraordinary loss Extraordinary item: Loss on earthquake destruction Net income {mospagebreak} Revenue / Net Sales: Revenue is classified as ‘Revenue from Primary Sources’ and Revenue from Secondary Sources’. Revenue from primary sources is also referred as ‘Operating Revenue’. For a manufacturer, revenue from the sale of manufactured goods would be its primary activity. Revenue from secondary activities would include the revenue or income generated from the non-operating activities. For example, interests received on cash investments, rent received from a vacant space, and gains on the sale of a long term asset would all be recorded under this heading. It is important to differentiate ‘Revenues’ from ‘Receipts’. As per the accrual basis of accounting, revenue is recognised in the income statement when the sale takes place and not when the cash payment is made. Cost of Sales: The cost of goods sold includes all the expenses which are directly related to the production process (core operations) of the business like raw material cost and direct labour costs. For example, the cost of goods sold for a car manufacturer would be the material costs for the parts that go into making the car along with the labour costs used to put the car together. The cost of selling the car would be excluded as this expense does not directly contribute to the manufacturing process. While there are many ways of calculating cost of sales, the most basic way is to add the total purchases to the beginning inventory for the period and deducting the ending inventory. An efficient and integrated business process helps the management in controlling the cost of sales. Gross margin: This indicates the profitability of the core operations of the business. The level of gross margin varies across industries. A service company will have a higher gross margin compared to a manufacturing company. While a consistently high gross margin indicates that a company is well positioned to support its indirect expenses, a consistently low gross margin is an indicator of future liquidity problems. Operating expenses: This includes expenses incurred by the company for running its operations during a given period of time. General administration expenses, selling and distribution expenses, research & development expenses and depreciation are the major items of consideration. Interest paid on loans taken to finance the business operations (long-term loans, debentures) are excluded from this line as this expense is the result of the managements financing decisions and not the result of business operations. Maintaining low operating expenses without affecting the ability to compete with competitors is a crucial challenge for the management. Operating income: Reflects the profit generated by the normal and recurring business activities of the company and does not take into account the gains from non-operating activities, interest expenses and taxes. Other income / expense: This includes income gained or expenses incurred due to transactions not related to the normal and recurring operating activities of the company. Items like interest and dividend income, profit or loss from the sale of fixed assets and restructuring expenses are all included under this heading. {mospagebreak} Extraordinary items: This includes one-time gains and losses incurred by the firm due to certain unforeseen events like natural calamities. Extraordinary income and gains are recorded as a separate line so that they don’t skew the company’s regular earnings. Net Income: This figure indicates the profitability of all the business activities during a given period of time. An investor should be very careful while analysing this figure as negative net income does not always indicate a bad performance and vice versa. Increases in certain expenses like restructuring expenses and research and development expenses will have a negative impact on the net profit of the current year, however, benefits can be reaped in the form increased profitability in the future of the business. Similarly, a positive net income may be due to ‘window-dressing’ by the company or a manipulation of accounting methods used. Key items to be considered while analysing the ‘Income Statement’: An income statement reveals much more than the earnings of the company. It indicates the efficiency of the management in controlling the expenses and financing the business operations. Ratios such as ‘rate of return’ on assets, investments and capital employed are the most commonly used ratios while analysing a company. However, a novice investor should be very careful while analysing the income statement of a company. The following are some of the ways in which a company can manipulate its bottom line to project an image of healthy profitability.