Income Statement: How to Read and Use It?

What Is an Income Statement?

An income statement is one of the three important financial statements used for reporting a company’s financial performance over a specific accounting period. The other two key statements are the balance sheet and the cash flow statement.

The income statement focuses on the revenue, expenses, gains, and losses of a company during a particular period. Also known as the profit and loss (P&L) statement or the statement of revenue and expense, an income statement provides valuable insights into a company’s operations, the efficiency of its management, underperforming sectors, and its performance relative to industry peers.

Understanding the Income Statement

The income statement is an integral part of the company performance reports that must be submitted to the U.S. Securities and Exchange Commission (SEC). While a balance sheet provides the snapshot of a company’s financials as of a particular date, the income statement reports income through a specific period, usually a quarter or a year, and its heading indicates the duration, which may read as “For the (fiscal) year/quarter ended June 30, 2021.”

The income statement focuses on four key items: revenue, expenses, gains, and losses. It does not differentiate between cash and non-cash receipts (sales in cash vs. sales on credit) or cash vs. non-cash payments/disbursements (purchases in cash vs. purchases on credit). It starts with the details of sales and then works down to compute net income and eventually 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).

Revenue and Gains

The following are covered in the income statement, though its format may vary, depending upon the local regulatory requirements, the diversified scope of the business, and the associated operating activities:

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 the 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 for offering those services.

Non-Operating Revenue

Revenue realized through secondary, noncore business activities is often referred to as nonoperating, recurring revenue. This revenue is sourced from the earnings that are outside the purchase and sale of goods and services and may include income from interest earned on business capital parked 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.

Gains

Also called other income, gains indicate the net money made from other activities, like the sale of long-term assets. These include the net income realized from one-time nonbusiness activities, such as a company selling its old transportation van, unused land, or a subsidiary company.

Revenue should not be confused with receipts. Payment 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 received.

A customer may take goods/services from a company on Sept. 28, which will lead to the revenue accounted for in September. The customer may be given a 30-day payment window due to his excellent credit and reputation, allowing until Oct. 28 to make the payment, which is when the receipts are accounted for.

Expenses and Losses

A business's cost to continue operating and turning a profit is known as an expense. Some of these expenses may be written off on a tax return if they meet Internal Revenue Service (IRS) guidelines.

Primary-Activity Expenses

These are all expenses incurred for earning the average operating revenue linked to the primary activity of the business. They include the cost of goods sold (COGS); selling, general, and administrative (SG&A) expenses; 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 such as electricity and transportation.

Secondary-Activity Expenses

These are all expenses linked to noncore business activities, like interest paid on loan money.

Losses as Expenses

These are all expenses that go toward a loss-making sale of long-term assets, one-time or any other unusual costs, or expenses toward lawsuits.

While primary revenue and expenses offer insights into how well the company’s core business is performing, the secondary revenue and fees account for the company’s involvement and expertise in managing ad hoc, non-core activities. Compared with the income from the sale of manufactured goods, a substantially high-interest income from money lying in the bank indicates that the business may not be using the available cash to its full potential by expanding the production capacity, or that it is facing challenges in increasing its market share amid competition.

Recurring rental income gained by hosting billboards at the company factory along a highway indicates that management is capitalizing upon the available resources and assets for additional profitability.

Reading Income Statements

The focus in this standard format is to calculate the profit/income at each subhead of revenue and operating expenses and then account for mandatory taxes, interest, and other nonrecurring, one-time events to arrive at the net income that applies to common stock. Though calculations involve simple additions and subtractions, the order in which the various entries appear in the statement and their relationships often get repetitive and complicated. Let’s take a deep dive into these numbers for a better understanding.