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If you are an employee in a small-medium enterprise or a large corporation, it is essential to know how to read and analyze an income statement. It is even more critical to have this skill if you own and run a business. Unfortunately, not many know how to do this because they leave it to accountants and depend on their already finished reports.
You might think that reading and analyzing an income statement is a complicated task, but its principles are pretty simple and easy to understand. Once you get the hang of it, you will eventually build up speed, and reading and analyzing an income statement will be much easier. With this in mind, in this article, you better understand what an income statement is, its purpose, and how to read and analyze it properly.
What is an Income Statement?
An income statement, also known as a profit and loss statement or earning statement, is a type of financial statement. It is considered to be among the most essential and helpful because it reports about a particular company’s financial performance over a specified accounting period.
Financial statements are necessary because they are often required for tax purposes. These are also some of the standard requirements of financial institutions when you plan to take out a loan. These are some of the vital information that you will get from a financial statement:
- Financial Performance – It informs business owners and other stakeholders about the financial position of the company. This helps them make informed decisions on the next course of action that would best benefit the company.
- Pinpointing Expenses – A financial statement will tell the stakeholders involved about the specific expenditure of the company and whether or not they were able to stay on budget.
- Overall Company Analysis- If you are looking for an investor or planning to apply for a loan, the income statement is good evidence to convince them that the business is profitable or can repay loans.
Essential Components of an Income Statement
Before jumping into reading and analyzing financial statements, it is essential to understand their major components. Here are they:
● Gross Profit – Gross Profit refers to the net sales subtracted from the total cost of goods or services sold by your business.
● Cost of Good Sold – Cost of Goods Sold refers to the manufacturing cost of the goods. Take note that this does not cover the overhead for services sold. Also, it shouldn’t be confused with gross profit because that is mainly the amount of money brought in when the goods are sold.
● Revenue or Sales – This is typically the first section of an income statement since it summarizes the gross sale made by the company. It can be categorized into two types; non-operating and operating. The non-operating revenue is earned by performing non-core business activities such as renting out properties, maintenance, etc. Meanwhile, operating revenue is the revenue earned by a business from doing its primary activities, such as providing services or manufacturing goods.
● Gains – Gains refer to the outcome of positive events that increase the company’s income. It indicates how much is realized from different business activities, such as operating segments or sales. Take note that gains are considered secondary revenue and are different from actual revenue from regular business activities.
● Expenses – Expenses refer to the cost that the company has to shoulder to earn revenues. This includes employee wages, supplier payments, depreciation, etc. There are two primary categories of expenses in an income statement; non-operating and operating expenses.
● Administrative expenses – Administrative expenses are the expenditure of a business as a whole instead of being specified per department. These are fixed, and they exist regardless of how much sales there is.
● Advertising Expenses – Advertising expenses are marketing costs required to expand the client base of the company. This includes how much is spent on online or print advertising.
● Depreciation – Depreciation is the practice of allocating the cost of long-term assets depending on their lifespan. It mainly shows the value of an asset used up by a company over a period. For example, if the company has a vehicle and its lifespan is only five years, its book value will diminish every year.
● Earnings Before Tax – This is considered to be a measure of the financial performance of the company. The figure is derived by subtracting the expenses from the income before taxes.
● Net Income – Net Income is the amount that a business earns that already has the allowable business expenses.
Step-by-step Guide on How to Read an Income Statement
Now that you understand what an income statement is and its main components, here are the steps on how to read and analyze it:
- Double Check the Math
The first step in reading and analyzing an income statement is to check all the math. Make sure that all the figures typed in are correct. This can be quite tedious because you may have to check the original documents such as receipts, invoices, etc. However, it is a good practice to avoid wrong assumptions later on.
- Compute the Bottom Line
The bottom line refers to the result when you subtract all the income from all the expenses. It’s the net income. The goal is to have it in a positive figure because that means that that company is earning money. However, if it isn’t, it means that it is losing money, and something needs to be done immediately to prevent the company from shutting down totally.
- Take a Closer Look at the Source of Income
The next step when reading and analyzing an income statement is to look at the source of income. When looking at it, ask yourself whether it makes sense or not.
For example, is the bulk of income mostly from sales of goods or secondary activities such as renting out a space owned by the business? If you realize that the business is earning more from its secondary activities, there might be something wrong with your goods or how you operate, and it’s up to them to make recommendations so that they can be changed.
- Examine the Expenses
Although expenses are necessary for a business to run, they should be allocated accordingly and translate benefits for its well-being. When reading and analyzing an income statement, you need to figure out whether the expenses are reasonable.
You also have to look at which expenses are the highest. Most of the time, it’s the salary expense.
- Compare it with the Previous Income Statement.
The last and final step when reading and analyzing an income statement is to compare it from the previous cycle. This will tell you whether its performance improved or not. You can simply look at the gross and net revenue for this.
It is also a good idea to take a close look at the expenses. See whether there is significant inflation and ask yourself whether that difference is justifiable. If it isn’t, you have to launch the proper investigation on why there is such a difference in the figures.
Reading an income statement is quite simple. The revenue minus all the expenses will show you the bottom line of the company. This will tell you whether it’s earning or losing money.
However, it does not end there. You can also use it to answer other business-related questions. For example, is it reasonable to increase employee salary and benefit given the company’s overall revenue? You can do this analysis using the income statement by thinking about the logical relationship between the figures and your questions and dilemmas.
Take Away
There you have, you now have a better understanding of what an income statement is and how to read and analyze it. With consistent practice and application, it will eventually be a piece of cake for you.