Understanding the Income Statement

The Income Statement – also referred to as the operating statement, profit and loss statement (P&L), earnings statement, or statement of operations – provides a summary of a company’s profit or loss during a specific time period. Together with the Balance Sheet, which provides information at a specific point in time, it is an important tool for vendors in determining the health of an organization.

Components of the Income Statement: What They Tell Us

1. Sales or Revenues (“Net Sales” on the sample): Often called the “top line,” it represents the amount the company sold during the period.
2. Cost of Goods Sold: The amount it costs to make or procure the products or services an organization sells. For manufacturing firms, this includes the direct cost of raw materials, labor, and manufacturing overhead to make the product. For wholesalers and retailers, it is the purchase cost of the merchandise sold. For service companies, it’s the direct costs involved in providing the service.
3. Gross Margin (“Gross Profit” on the sample): May also could be “Gross Loss”, this represents Net Sales – (minus) Cost of Goods Sold. It’s important to look at this number over time, as a trend. If there is an increase in sales, with a drop in the gross margin to sales ratio, it’s an indication the company is growing weak on the top line and may be in jeopardy.
4. Selling, General, and Administrative Expenses (SG&A): Often called “overhead” or “fixed costs”, these represent the organization’s operational expenses not directly related to making or procuring their products/services. For instance: salaries, commissions, marketing costs, utilities, insurance, office supplies, etc. The goal is to keep these expenses as low as possible. The trend of these expenses as a percentage of sales should be watched closely to detect signs of managerial inefficiency.
5. Operating Income: Represents gross profits – (minus) SG&A. The company’s earnings from its normal operations, before interest, non-operating income and costs, taxes, etc. Operating income is viewed by some analysts as more reliable than net income as a measure of profitability.
6. Interest Expense: The costs of the company’s credit lines and other borrowings.
7. Other (Income) Expense: Items not related to the primary business activities of the company, for instance income from subletting space, patents, unusual or infrequent gains and losses.
8. Income Before Income Taxes or Pretax Income: This is exactly what the name describes. As there are many ways to avoid or decrease income tax expense, some analysts consider this pretax income as an accurate measure of the company’s profitability.
9. Provision for Income Taxes: What the organization expects to have to pay in income taxes for the period.
10. Net Income: Called the “bottom line” – because it actually is the last line of the statement. This is the profit (or loss) for the period covered by the Income Statement. Obviously, you want to see a positive number here; the higher, the better.

Sample Income Statement: Acme Manufacturing

While a credit decision should never be made looking at one financial statement alone, Acme Manufacturing’s Income Statement (seen below) can be assessed through a variety of ratios and formulas to general show business health.

Using the Income Statement to Determine the Financial Health of a Business

Ratio analysis is the primary means of determining the overall financial condition of a potential customer. Ratios are even more valuable when you apply them to multiple years of a company’s income statements to establish a trend, or obtain industry average ratios with which to compare results. There are many ratios, and formulas for those ratios, used in financial analysis. We cover just a few of them below.

Income Statement Ratios

These ratios utilize figures from the Income Statement alone.

Gross Margin Ratio: Gross Profit ÷ Net Sales. This measures the percentage of sales dollars available to pay the overhead expenses of the company.

A related ratio is the Net Profit Margin Ratio: Net Income Before Income Taxes ÷ Net Sales. Both ratios determine the percentage of profits for each sales dollar obtained. The higher the ratio, the higher the profit margin.

Example #1: Acme Manufacturing Gross Margin and Net Profit Ratios

[Income Statement Chart]