Components, Uses and Advantages of an Income Statement / Profit and Loss Statement
Table of Contents
1. Income Statement Definition
The income statement, also referred to as the profit and loss statement, is one of the three major financial statements. It measures a company’s revenues and expenses over a certain period of time. In general, businesses need to record their incomes and expenses for tax purposes. Yet, there are also many benefits from an analytical point of view.
Income statements have become fairly complex and can differ from company to company to the extent that legal guidelines allow. As an analyst, it is essential to know how income statements are structured and how to read them properly.
Therefore, let’s look at the components of an income statement in a bit more detail.
Note: If not stated otherwise, the content of this article focusses on the income statement according to the International Financial Reporting Standards (“IFRS”).
2. Components of an Income Statement
Under IFRS, companies can structure their income statements according to the “function of expense” or the “nature of expense” method. The income statement by nature method discloses the expenses in line with their nature, e.g. salaries, depreciation and rent. The function of expense method allocates portions of these expenses to different functions such as costs of goods sold, administrative expenses and marketing costs. As a result, for example, rental costs can spread across most of the functions, as every department needs offices to work in.
The following explanations focus on the income statement according to the function of expense method, which is predominant with larger companies.
Revenue represents charges to customers for goods and services and is the product of price and volume. It is usually the first item on the income statement and is often also referred to as the “top line”.
Moreover, it is essential to know that the revenue on the income statement can vary from the actual cash received. Once a company sold its product or rendered its services, it will either receive payment in cash or on credit. While the revenue must be recognized on the income statement immediately, which is called the revenue recognition principle, it will be deducted on the cash flow statement until the actual payment occurred.
Some companies even split their revenues to allow investors to see which products and countries are contributing the most to the company’s success.
2.2. Costs Of Goods Sold (“COGS”)
The costs of goods sold, or short “COGS”, are mainly costs that are directly attributable to the manufacturing of the product. Those are, amongst others,
- costs of materials,
- costs of storing the materials and goods,
- direct labor costs for the staff manufacturing the goods, and
- other overhead costs.
A Rule of Thumb:
If the costs occur, even though no products were sold, it is not considered a cost of goods sold. Instead, it would rather be part of the operating costs, e.g. administrative expenses.
2.3. Gross Profit
The gross profit is the difference between revenues and costs of goods sold. It essentially shows the net value of the revenues after COGS have been subtracted.
A common metric that is used to compare companies is the gross profit margin, which is the ratio of gross profit to revenues.
Gross Profit = Revenues – COGS
Gross Margin = Gross Profit / Revenues
As an example, let’s look at the gross profit and the gross margin of Walmart and Facebook.
As can be seen, Walmart has a significantly lower gross margin. That does, however, not mean that Walmart is operating worse than Facebook. Keep in mind the different business models of the two companies. Walmart is buying and selling groceries, and, therefore, has fundamentally different costs of goods sold than Facebook, which is offering digital services with limited direct costs.
As a consequence, the gross margin should only be used to compare companies that are similar in terms of how they generate revenue.
2.4. Operating Expenses (“OpEx”)
Operating expenses (“OpEx”) are mostly indirect expenses that a company incurs by way of performing their everyday business operations. It should not be confused with capital expenditure (“CapEx”), which is attributable to the purchase, maintenance or improvement of assets.
Let’s look at an example: When a company acquires a car, the purchase price is considered a capital expenditure. Operating expenses would be the costs to operate the car, e.g. gas and insurance.
What’s more, companies tend to show the following subcategories of operating expenses on their income statement instead of the lump sum:
- Selling, general and administrative expenses (“SG&A”), which are, amongst others, selling costs, salaries and warehousing
- Research and development (“R&D”), which are the expenses that occur due to the development of new goods and services
- Marketing expenses, which are marketing research costs, promotions and advertising
On comprehensive income statements, these subcategories are broken down into even more specific line items. The more detailed the P&L, the more conclusions an analyst can draw when assessing the company.
2.5. Other operating income
Further to their main business, companies can generate income through other operations. As these income streams are considered non-core, they are not part of the revenue line. However, they still add to the taxable income and, therefore, must be listed on the income statement.
As an example: Consider a company that owns an office building. However, they do not fill all the empty spaces themselves and, therefore, decided to lease some offices to other companies. The generated rental income would be considered non-core and show up as other operating income on the income statement.
Another example would be a retailer that sells expensive electronic goods. To enable more customers to buy their products, they offer a vendor loan. The vendor loan is paid back through monthly payments over a certain period of time, plus an interest charge. In that case, the interest payments to the company are also considered other income.
2.6. EBITDA in an Income Statement
EBITDA stands for earnings before interest, tax, depreciation and amortization. It is an important, if not the most important, financial metric amongst analysts. But why is that?
EBITDA shows the operating profit of a company. However, it excludes certain costs that may vary from company to company due to different tax-regulations, depreciation and amortization methods as well as financing structures.
Let’s assume we compare two companies that have the same operations, revenues and operating costs, yet, they are located in different countries. One company sits in Australia and has a corporate income tax of 30%, while the other company is in Singapore with a 17% corporate income tax. If an analyst would now compare the two companies on a net income level, the company in Singapore would look much more profitable due to lower taxes and hence higher net income.
The same holds true for depreciation and the financing structure. While different depreciation methods across tax jurisdictions lead to different taxable incomes, varying financing structures are responsible for differing costs of capital.
As a matter of completion, it must be noted that companies generally pull “one-off” items below EBIT. These costs or incomes represent an isolated event that is not considered to occur again. Therefore, by nature, they should not be part of the operating profit (EBIT), yet, are reflected in net income.
In conclusion, it is the analyst’s job to make the companies comparable. That essentially means comparing apples to apples, and EBITDA represents exactly that very apple in the equation. As a result of this, EBITDA is commonly used for valuation purposes.
Let’s look at our example of Walmart and Facebook again. Absolute figures are not very useful when comparing EBITDA of companies of different sizes. Therefore, analysts calculate a ratio of EBITDA to revenues, the so-called EBITDA margin. In our example of Walmart and Facebook, we have two substantially different business models, so a comparison of both companies’ EBITDA margin might prove difficult. To get a better view of how profitable Facebook really is, a comparison to, for example, Instagram would seem reasonable.
2.7. Depreciation & Amortization (“D&A”) in an Income Statement
Depreciation is the accounting term for the write-off of tangible assets over their useful lives. Tangible assets are, amongst others, property, equipment, vehicles and IT.
Let’s look at an example. A company buys a car for €100. The useful life of the vehicle is 10 years, and the company is using the straight-line method. After the first year, the company writes off 10% (1 of 10 years) of the initial purchase price of the car and, therefore, incurs depreciation cost of €10 on their income statement. The company is not allowed to recognize the cost of €100 in a single year immediately but has to capitalize it on the balance sheet and subsequently spread the costs across the useful life of the asset.
Amortization is very similar to depreciation. It, however, concerns the write-off of intangible assets, which are, e.g., trademarks, patents, and copyrights.
Not all assets are depreciable or amortizable. For example, land is usually exempted from depreciation, as its useful life is not considered to be limited.
On a side note: As depreciation is a nature of expense, it is often spread across the functions and, therefore, most income statements will not directly disclose D&A. However, as EBITDA is an important metric for investors, it is often disclosed on a note to the income statement.
The underlying principle behind depreciation and amortization is that assets lose value over time. This reduction of value should be accounted for on the balance sheet as well as the income statement. Not, however, on the cash flow statement, as no cash is involved.
2.8. EBIT in an Income Statement
Earnings before interest and taxes, or short “EBIT”, results from subtracting depreciation and amortization cost from EBITDA.
While companies that follow an asset-light business model will only have a minor gap between EBITDA and EBIT, other businesses’ depreciation costs might have a more severe impact on EBIT.
Similar to EBITDA, EBIT is often utilized in valuation, and analysts will calculate an EBIT margin to compare companies of different sizes.
2.9. Net Interest Income
Net interest, sometimes also referred to as net interest income or “NII”, is the difference between interest income and interest expense.
Interest income is the income on cash in savings accounts, money market funds, deposits and other investments. Interest expense is the interest to be paid on debt that the business borrowed.
EBT stands for earnings before tax. It is sometimes also called pre-tax profit. As with EBITDA and EBIT, it ignores the effect of taxes on the company’s performance, yet, includes the impact of D&A and interest.
Corporate taxes are compulsory financial charges on a company’s operations. Corporate income tax is charged on the pre-tax profit (EBT).
It is essential to know that different tax jurisdictions might charge different corporate tax rates. This can be the case on a federal level, i.e. between countries, but also between states.
For the different corporate tax rates, please refer to this overview by KPMG.
2.12. Net income – Bottom Line of the Income Statement
Net income is the bottom line of every income statement. Other names for net income are net earnings or net profit.
Publicly traded companies use net income to calculate their earnings per share (“EPS”). Moreover, it is also the basis for possible dividend payments.
What’s more, net income is the first item on the cash flow statement. Following the payment of dividends, the remaining portion of net income flows into retained earnings on the balance sheet.
3. Income Statement Template for Excel
4. What are the advantages of an Income Statement?
The following examples provide an overview of what an income statement can tell you about a company:
- It allows getting an overview of the magnitude and development of the revenues. An analyst can see from the development of revenue over time, if and how quickly the company is growing. This allows, amongst other things, for the comparison of companies. While two companies might have the same revenue in one year, one could have had no growth over the past years, while the other one grew double-digit.
- Some income statements allow for the composition and origin of revenues. Those income statements split – or have an accompanying note to – their revenues that allow investors to see which products and countries are contributing the most to the company’s success. As an example, Apple splits its revenue into iPhone, Mac, iPad, Wearables and Services.
- The income statement tracks the performance of the company. It enables to calculate important key performance indicators, for example, the gross margin, EBITDA margin, or net income margin. When comparing these to similar companies’ KPIs, it might give a first impression on how efficient the company is operating.
- It allows investors to see how much net income and, therefore, how much money is distributable to shareholders. Investors are eligible for dividends. Dividends can only be paid out in the amount of net income of the company. Therefore, net income is an important metric for investors.
- Although historical performance is not a guarantee for future performance, the income statement might give analysts and investors a first glimpse of how the company might perform in the future. If a company was already quite inefficient over the past years, the chances are low that their profit will go through the roof over the next months.
- EBIT and EBITDA, which can be found on an income statement, are commonly used metrics in financial modeling and valuation. So even for readers that are not that familiar with valuation, the application of industry multiples is an easy and quick way to get an approximate value of a company.