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Understanding the Income Statement

Examining the Components and Ratios of an Income Statement To Show Business Health

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.

Gross Sales $1,909,200
Sales Returns and Allowances $18,000
Sales Discounts $27,200 ($45,200)
Net Sales $1,864,000
Cost of Goods Sold ($1,262,500)
Gross Profit $601, 500
Expenses
Selling $261,700
Administrative $85,000 ($346,700)
Income Before Interest Items and Taxes $254,800
Interest Revenue $3,400
$254,800
Interest Expense ($26,500)
Net Income Before Income Taxes $231,700
Income Tax Expenses ($93,600)
NET INCOME AFTER TAXES $138,100
* Depreciation – Building ($33,000) and Equipment ($22,200) – are included in manufacturing overhead as apart of Cost of Goods Sold

 

 

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

2020
Gross Margin $601,500 ÷ $1,864,000 =
32.27%
Net Profit Margin $231,700 ÷ $1,864,000 =
12.43%

 

[Income Statement Chart]

 

Other Ratios Utilizing Both the Income Statement and Balance Sheet Information

Inventory Turnover Ratio: Net Sales (Income Statement) ÷ Inventory (Balance Sheet).
“Net Sales” is for the entire period (in this case the year) and “Inventory” represents the inventory balance at the end of the year. The Inventory Turnover ratio measures the efficiency of inventory management. The more times inventory is turned in an operating cycle, the greater the profit.

Example #2: Acme Manufacturing Inventory Turnover Ratio

2020
Inventory Turnover $1,874,000 ÷ 158,600 =
11.82 times

 
[Income Statement Chart]
 

Return on Equity: Net Profit after Taxes (Net Income on Income Statement) ÷ Net Worth (Total Stockholders’ Equity on Balance Sheet). This ratio measures the ability of the company to realize an adequate return on capital invested by the owners. The higher the number, the more efficient management is utilizing this capital.

Example #3: Acme Manufacturing Return on Equity Ratio

2020
Return on Equity $138,100 ÷ $1,165,200 =
11.85%

 
[Income Statement Chart]
 

Return on Assets: Net Profit after Taxes (Net Income on Income Statement) ÷ Total Assets (Balance Sheet). This ratio indicates how efficiently management is using its assets to generate earnings. An increase in this percentage is a positive sign.

Example #4: Acme Manufacturing Return on Assets Ratio

2020
Return on Assets $138,100 ÷ $1,724,000 =
8.01%

 
[Income Statement Chart]
 

Assets to Sales: Total Assets (Balance Sheet) ÷ Net Sales (Income Statement)
This ratio measures the percentage of investment in assets that are required to generate the current annual sales level. A high percentage may indicate that a business is not aggressive in its sales efforts or is not fully utilizing its assets.

Example #5: Acme Manufacturing Assets to Sales Ratio

2020
Assets to Sales $1,724,000 ÷ $1,864,000 =
92.49%

 
[Income Statement Chart]
 

Accounts Payable to Sales = Accounts Payable (Balance Sheet) ÷ Net Sales (Income Statement)
This ratio measures how the company pays its suppliers in relation to the sales volume being transacted. A low percentage indicates a healthy ratio. A high percentage may indicate the business is using suppliers to help finance operations.

Example #6: Acme Manufacturing A/P to Sales Ratio

2020
A/P to Sales $100,500 ÷ $1,864,000 =
5.39%

 
[Income Statement Chart]
 

 

Conclusion

As you can see, the Income Statement and Balance Sheet are valuable sources of information for the credit manager. Both are available for all U.S. public companies. Unfortunately, they are difficult to obtain from private U.S. firms.