The income statement or profit and loss statement (P&L) is a summary of the annual revenues, costs, and profits/loss, and is one of the three financial indicators in addition to balance sheet and cash flow statement.
As opposed to the cash flow statement, the income statement registers income and expenses at the accrual date. For instance, when a company receives a bill, it shows up in the company's income statement the same day when the bill is incurred. Note that in a cash flow statement, the cost is not accounted for as cash outflow until the bill is actually paid.
The following are some common terms found in an income statement
- Operating revenue relates to all revenue generated as part of the regular business of a firm.
- Operating costs are subdivided into COGS (costs of goods sold) and SGA (selling, general and administrative costs). COGS are directly caused by producing goods, such as material costs or the amount of labor used. SGA refers to costs that cannot be easily attributed to a single product, such as general brand advertisement. This cost differentiation is analogous to fixed and variable costs.
- Gross profit is operating revenue minus the operating costs, resulting from the core business of a firm.
- Non-operating revenue and cost are non-business-related incomes and expenses, such as revenue from selling real estate or costs of a lawsuit.
- Depreciation refers to the loss of value of assets, for example, used machines that become outdated over time.
- Interests are costs of debts. The debts are listed on the balance sheet.
- Taxes are paid on the EBT.
Determine specific ratios and track them over time to get insights
The income statement is a great tool to determine the profitability of a firm. Looking at financial ratios, the variety of possible profitability measures allow deeper analysis and comparison of firms (see benchmarking).
The gross profit margin provides the profitability of the pure core business, taking into account only operating revenue, COGS, and SGA.
For operating margins, non-operating costs and revenues are taken into account. Also, depreciation can be included as it is closely linked to a firm's business, especially in asset-heavy industries.
The net profit margin considers all costs, also interest, and taxes.
If net profit margins are different, but operating margins are the same, you can infer that the variance is not directly caused by the core business, but rather due to differences in tax and interest payments. If you compare profit and loss statements from consecutive years, you will identify suspicious trends, which can be useful for solving a case. The cost breakdown of an income statement is MECE and can be used as an issue tree while solving a profitability case.
Key takeaways
- An income statement provides an overview of the income and expenses at a given time period.
- Income statements provide an overview of revenues and costs at the accrual date.
