While the balance sheet shows a snapshot in time of assets owned and liabilities due, the income statement details performance of the business over a set (usually 1 year) period. It outlines revenues earned and expenses incurred to arrive at net profit or loss for the company over the reporting period. Generally, income statements span one quarter or one year. Note that revenue ‘earned’, and expenses ‘incurred’ doesn’t necessarily mean the cash is received or paid. Hence the need for the Cash Flow Statement, to identify those differences.
How is the income statement calculated?
Starting at the top line of the P&L and working down the statement, the order of items is consistently presented. The top line shows operating revenues – those earned from the company’s core business activities (delivering services or selling goods). They do not include earnings from selling non-current assets, for example, or investment income.
Common expenses include cost of goods sold, sales and marketing costs, research and development costs, and general and administrative expenses.
Revenue less Cost of Goods Sold gives what is known as Gross Profit. Note that Cost of Goods Sold is named as such for a very good reason! – it is only the cost of the goods sold to customers that is included, not the cost of what has been purchased in the period. Then subtracting other operating expenses (sales, marketing, distribution) from revenues gives operating profit.
Then finance-and tax related items are added / deducted to arrive at the final net profit (also ‘net income’) or loss.
Common Income Statement Analysis Tasks
Using the income statement, analysts and investors will typically:
- Analyse income statement trends over time, especially for revenues, expenses, and profit margins
- Look at growth rates and profitability ratios like gross margin, operating profit margin and net margin.
- Compare to peers and industry averages and past performance to gauge operational efficiency and management effectiveness.
- Identify major variances from prior years and their underlying causes
This will provide some insight as to whether the business is improving, deteriorating and whether management strategy is working to improve returns to shareholders
Impact of Non-recurring Items on Income Statements
Non-recurring items, which are unusual and infrequent in nature, can significantly impact a company’s income statement. It’s important to identify and understand these items, as they can distort the true operating performance. Adjusting for extraordinary items provides a clearer picture of a company’s recurring profitability and operational efficiency. Adjusting for these, we essentially remove ‘noise’ from our analysis. Of course, you cannot ignore them altogether as they can be ‘red flags’ that require further interpretation or analysis. But by removing them it does help clarify the picture of underlying performance. We often talk about underlying earnings, or underlying EBITDA.