How to Read and Analyze an Income Statement

how to read an income statement

A horizontal analysis, on the other hand, shows a company’s consistency and growth over time, which is useful when analyzing a company’s financial performance. In summary, understanding the structure of an income statement is vital for evaluating a company’s financial performance. Familiarize yourself with the components, and pay attention to the format used, whether it’s a single-step how to account for outstanding checks in a journal entry or multi-step income statement, to make informed decisions about the company’s profitability and financial health. It shows the profitability of a company over a specific period of time. The following guide shows you how to prepare a simple multi-step income statement. A multi-step income statement separates operating income and expenses from non-operational gains and losses.

Profit and Loss Trends

  1. This can also be referred to as earnings before interest and taxes (EBIT).
  2. Creditors may find income statements of limited use, as they are more concerned about a company’s future cash flows than its past profitability.
  3. This figure represents the company’s earnings after expenses, such as production costs and operating expenses, are deducted but before tax expenses are applied.
  4. In other words, it’s the profit before any non-operating income, non-operating expenses, interest, or taxes are subtracted from revenues.

Net income margin should be increasing steadily or be relatively stable over time, as this shows the company is consistent or becoming more efficient over time. Cost of goods sold (COGS) (aka Cost of Sales) represents the component costs directly related to the sale of the company’s products. For pure-service businesses (e.g., mobile apps), COGS does not exist, because there’s no physical products being sold. Even if a business provides a combination of services and physical products to their customers, COGS (in its literal definition) only represents the physical component parts that are required to make whatever the business sells.

Losses as Expenses

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.

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Here’s an income statement we’ve created for a hypothetical small business—Coffee Roaster Enterprises Inc., a small hobbyist coffee roastery. Here’s an example of an income statement from a fictional company for the year that ended on September 28, 2019. To elaborate, this is because companies often compensate their managers with “convertible shares,” which means that these managers will only receive a certain amount of shares if the company’s stock price reaches a certain price. Therefore, if the stock price performs well and these performance measures are met, these managers will receive these shares (which do not currently exist). Because there are more diluted shares outstanding, profit will be split between more shares, which reduces the EPS number. As a result, to be more conservative in your evaluation, it’s recommended that you use the diluted numbers instead and assume that all potential shares will eventually be converted into actual shares.

Link to Cash Flow Statement

There are situations where intuition must be exercised to determine the proper driver or assumption to use. Instead, an analyst may have to rely on examining the past trend of COGS to determine assumptions for forecasting COGS into the future. Next, analyze the trend in the available historical data to create drivers and assumptions for future forecasting.

In other words, it is the net income before considering tax obligations. To summarize, understanding the breakdown of expenses on an income statement is crucial for analyzing a company’s financial health. Grasping the differences between COGS, operating expenses, and non-operating expenses enables you to identify the primary drivers of a company’s profitability and make informed decisions. Along with balance sheets and cash flow statements, income statements are one of the three financial statements essential for measuring your company’s performance. Income before taxes represents a company’s profitability after all deductions, besides taxes, have been made against revenue. It deducts non-operating expenses, which are simply expenses incurred from activities not related to the core operations of the business.

Below is a video explanation of how the income statement works, the various items that make it up, and why it matters so much to investors and company management teams. After deducting all the above expenses, we finally arrive at the first subtotal on the income statement, Operating Income (also known as EBIT or Earnings Before Interest and Taxes). Comparing net sales across different financial periods reveals insights into the company’s sales performance, efficiency, and customer satisfaction levels.

how to read an income statement

Our expert bookkeepers here at Bench have built an income statement template in Excel that you can use to assess the financial health of your business and turn your financial information into an income statement. These expenses are listed individually here, but some income statements will bundle these and other similar expenses together into one broad category called “Selling, General & Administrative Expenses” (SG&A). Gross profit tells you your business’s profitability after considering direct costs but before accounting for overhead costs. While the definition of an income statement may remind you of a balance sheet, the two documents are designed for different uses. An income statement tallies income and expenses; a balance sheet, on the other hand, records assets, liabilities, and equity.