Income Statement Format And Elements
Income statements provide 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. We will go over a basic income statement format, and some of the elements you should consider inside of it in this article.
Income Statement Format
While the following section describes the common elements of income statements, the format of income statements will vary according to the complexity of business activities. Here is a very basic income statement example.
Elements Of An Income Statement
Revenue / Net Sales
Our first look into income statements we will briefly cover the revenue aspect. 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 recognized in income statements 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 that are directly related to the production process, or the core operations of the business like raw material cost, and direct labor 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 labor 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.
This indicates the profitability of the core operations of the business. The level of gross margin varies across industries, as in a service company would 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.
This aspect of income statements includes expenses incurred by the company for running its operations during a given period of time. General administration expenses, selling and distribution expenses, research and 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 management 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 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.
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.
This income statements figure indicates the profitability of all the business activities during a given period of time. An investor should be very careful while analyzing this figure as negative net income does not always indicate bad performance and vice versa. Increases in certain expenses like restructuring expenses, or 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 of 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 analyzing income statements:
Income statements reveal much more than the earnings of the company. They indicate the efficiency of the management in controlling 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 analyzing a company. However, a novice investor should be very careful while analyzing 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 using income statements:
The revenue figure for the current year can be inflated by advancing the sales of the following year.
– Altering other income like sales of fixed assets.
– Changing the rate or method of depreciation.
– Capitalizing expenses like research and development and product promotion costs that are usually written-off in the year that they are incurred.
– A company can defer expenses like training, advertising, research and development for the following year.
Now that we have shown you a basic income statement format and some of its elements to consider, lets move on from income statement examples and read our article on actually analyzing these income statements, and how the elements are calculated. You can read these here.