How to read the income statement

The income statement is one of the fundamental accounting documents that reflect the financial position of an organization or business. Whether in an annual, quarterly or monthly reports, managers can assess the profit or loss of their operations through the income statement.

The development of this financial statement is straightforward, but its analysis requires some accounting knowledge to identify information that will improve revenues and reduce costs in future years.

What is an income statement?

The income statement, also known as the profit and loss statement, is a summary accounting document that is used to define the profitability of a company over a given period. It includes revenues and expenses and the difference between the two to determine whether the company is profitable or not.

Revenues and expenses can be related to the operating and non-operating activities of the business. The income statement is aligned with the statement of financial position (balance sheet) and the statement of cash flows to provide a comprehensive view and analysis of financial performance in the short, medium and long term.

What is a compilation engagement?

Why produce this accounting report?

The preparation of an income statement is essential for managers, investors and creditors.

Directors:

• Compare financial results to corporate objectives in order to optimize the organization's future strategies;
• Set a budget that is appropriate for the expenses required to generate the expected revenue;
• Identify the most profitable activities;
• Deduce significant financial ratios;
• Determine the load distribution.

Investors and shareholders:

• Evaluate the profitability of the company to invest more or to withdraw from it;
• Strengthen the company's image to acquire new investors;
• Determine the net profits of each shareholder if the company decides to distribute its profits for a given period.

Creditors:

• Help creditors and lenders assess the company's financial situation before granting a loan or other type of financing.

Have a CPA prepare your income statement

Example of an income statement

To develop an income statement, you need to have a set of information about the revenues and expenses of your business:

• Total sales or service revenues;
• Direct costs (salary and commissions, depreciation expenses, cost of raw materials, etc.);
• Indirect costs (selling expenses, administrative expenses, etc.);
• Other costs (interest charges, one-time expenses, etc.);
• The amount of your business taxes;

The content of the income statement may vary from company to company, depending on the activities carried out, the size of the company and the accountant's choice of presentation. For example, some companies break down their operating expenses into several sections, while others present these expenses in a single line. The following is a fictitious example of an income statement:

Company: La soupe du chef

Statements of Operations for the period January 1st to December 31st 20XX (in thousands of dollars)

Some definitions related to the income statement concept

In order to extract the financial information needed to adjust the company's financial plan, it is wise to know the definition of some terms used in the income statement.

• Revenue: the turnover generated by all sales in a given period, after taking into account purchase discounts and rebates.
• Cost of goods sold (COGS): these are costs that are directly related to the products sold such as the cost of labor to produce the product or provide the service, raw materials and costs.
• Gross margins: also called gross profit, it is the difference between revenue and COGS.
• Operating expenses: these are expenses that are not directly related to production and are not included in the COGS, such as business management costs, rent, utilities, marketing and hardware expenses, employee benefits, etc.

Operating expenses = general expenses + selling expenses + administrative expenses

• Overheads: These are the costs associated with the day-to-day operation of the business. For example, housing costs, office supplies and computer equipment, etc.
• Selling costs: these are the costs spent during the process of distribution and marketing of the product (transportation of goods, costs of marketing campaigns, salaries and bonuses of salesmen, etc.).
• Tax burden: these are the amounts that correspond to the taxes that companies must pay to federal and provincial authorities.
• Fixed costs: These are indirect costs that do not depend on changes in the volume of production, such as rent and salaries, except for sales-related commissions. Fixed costs can also include semi-variable costs that vary slightly with the quantity produced, such as electricity costs.
• Variable costs: these are the COGS associated with the manufacture of a product or the creation of a service.
• Earnings before interest and taxes (EBIT): refers to net income before interest and taxes. This indicator, also known as operating income or operating profit, accurately describes the operating potential of the company.
• Net earnings: This is the total amount of profit or gain after deducting all expenses.
• Earnings per share (EPS): This indicates the consolidated net earnings divided by the number of shares comprising the capital of a company. It measures the profitability of the company to its shareholders. EPS is calculated as follows:

(Net earnings - Preferred share dividends) / number of common shares outstanding

• Interest expense: this is the interest paid on the company's outstanding debt.

How to read the income statement

After producing the income statement, you need to know how to analyze the profitability of the business. To do this, you need to familiarize yourself with the various indicators presented and deduce other useful ratios to better understand the financial situation of your business.

Difference between compilation engagement, review engagement and audit

What are the key data elements of an income statement?

• Turnover: it provides information on the reliability of the marketing process and the demand for the products and services offered by the company;
• Cost of goods sold and operating expenses: they tell accountants how the total costs are distributed and how to save on costs (raw material, energy consumption, production technology, etc.).
• The operating result: this is the major aggregate that reflects the economic profitability of the company's activities.

Break-even calculation

The break-even point is the minimum number of sales at which the result becomes positive. The break-even point is obtained by dividing the indirect costs by the gross margin (in %).

Gross margin = (gross margin/goods sales) x 100

Example of break-even calculation:

Suppose a company sells a product for $ 25. Its gross margin is 40% and its overhead costs are worth $ 30,000.

In money, the break-even point is:

30 000 $ / 40% = 75 000$

The company must achieve this turnover to reach its break-even point.

In units, the break-even point is:

75,000 / $ 25 = 3000 units In other words, the company needs to sell 3000 units to break even.

Other ratios from the income statement

By analyzing the income statement, we can deduce important indicators that tell us about the different financial aspects of the company. Here are some of them:

• Debt repayment capacity = financial debt / revenue
• Debt ratio = interest expense / sales
• Economic profitability rate = operating income / sales
• Personnel efficiency = turnover / personnel costs

Important notes when analyzing an income statement

1. A profitable business is not necessarily a business that makes money

It is common for start-ups and fast-growing companies to have low or even negative net profits. This does not imply that the business is loss-making, but is explained by the high level of investment in assets (equipment, buildings, inventory, accounts receivable) to meet the needs of the growing production.

2. A loss-making company is not necessarily a company that is short of money

A loss-making company does not mean that it does not have enough money. The losses incurred can be largely covered by the investment capital needed to continue the business.

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