What is an Income Statement, and Why is it Important?

A crucial document of financial information for any company is an income statement. Often referred to as a profit and loss (P&L) statement or an earnings statement, the income statement provides an overview of a company’s financial performance over a certain time period by listing revenues, cost of goods sold, expenses and net profit that can be attributed to shareholders.

Basis the statement, investors, lenders and other stakeholders evaluate a business’s financial health and make decisions that may have an impact on the future of the business.

What is the key purpose of an income statement?

The main objective of an income statement is to demonstrate how much profit or loss a company made within a reporting period. It allows investors and lenders to compare different time periods to evaluate the long-term growth trajectory and examine trends in each of the revenue and expense line items of the business.

Besides, an analyst can gain solid insights from an income statement with the use of ratios like return on equity (ROE), P/E ratio, and gross and operating margin ratios.

However, the objective of the income statement can vary depending on the individual who uses it. For instance, for a lender what matters is making enough profit to cover expenses and debts but for an investor consistent profit for business viability is a key concern.

What is the importance of an income statement?

Considered to be one of the key financial statements, business owners and entrepreneurs alike often examine an income statement to gauge how well a business is performing in comparison to anticipated future performance. They then use this knowledge to modify their course of action. 

For instance, a business owner whose company falls short of goals may change course to make up ground the next quarter. Likewise, an investor may choose to sell off an investment and put money into a business that is growing at an exponential level.

In addition, potential future investors use the statement to analyze the financial health of the business, growth and profitability, in order to make an investment decision.

What are the three key elements of an income statement?

An income statement is often created on a monthly basis, with quarterly and annual totals added up. While there could be a lot of components to spot spikes and dips, the three key elements businesses should be familiar with are revenue, expenses and profit.

Each of these elements includes subsegments of data pertaining to the cash the business has received (revenue), the cash it has spent on essential services or commodities (expenses), and the sum of the cash received after subtracting expenses (profit).

1. Revenue

Revenue is the company’s top line which is listed at the top section of the income statement. It shows the total revenue or gross profit made over a certain time period.

It is classified into two types — operating and non-operating revenue or income. Operating revenue is the profit generated from regular operations, such as sales. Whereas, non-operating revenue comes from a variety of sources, including installation, operation or rental interest on commercial real estate such as business property.

2. Expenses

Each business division is affected by the expenses incurred. Similar to revenue, there are two main categories for business expenses — operating and non-operating expenses.

Non-operating expenses cover everything that is not related to the business’s regular operations such as investment payments, COGS and inventory purchases. Whereas marketing, payroll, rent and utilities, office supplies, insurance, equipment and legal fees can all be included in operating expenses.

3. Profit

The term ‘bottom line’ is a reference to profit, which is listed in the last line of the statement. Also termed as net profit, it is the total revenue a company brings in over a given time period after deducting total expenses.

How to use an income statement?

Entrepreneurs and investors can leverage this rich source of financial information in multiple ways from strategic planning and budgeting to financial forecasts. If monitored and analyzed properly, the income statement can be used to gain valuable insights that will help in operating the business at an optimal level.

With a detailed list of expenses and losses, it’s easier to compare the business’s bottom line to the top line which will help in trimming the excess spending, if any. If the bottom line is expanding significantly, business owners can make a systematic plan to allocate money for growth and expansion; and if the bottom line is declining, they need to concentrate on financial planning, budgeting and forecasting.

Most importantly, investors offer counsel based on their evaluation of the income statement that covers various business aspects like managerial effectiveness, operations, potential profit leaks, and whether the business is functioning in line with its competitors.

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This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact us here.