How to interpret an income statement


The income statement is also called “Statement of Operations” or “Statement of Profit and Loss (P/L)”. The income statement captures the finances of the operations of a business. It is used to track all of the income and all of the expenses, and the resulting profit and losses.

In theory, the income and the expenses could be captured under “Retained Earnings” on the balance sheet, but it makes a lot of sense to track the details on a separate statement.

On the income statement we capture:

  • The revenue (also called sales, or turnover): The income the company makes through sales of its products and services.
  • The direct operating costs: Purchased inventory, and other direct costs associated to produce the goods or services.
  • The indirect operating costs (also called “SG&A” or “G&A”): Salaries, Research & Development, Administration, Selling, and Distribution.
  • The cost of debt finance: Interest and Bank charges.

Calculating the Profit and Income

If we deduct the Direct Operating Costs from the Revenue, we arrive at Gross Profit.

Gross Profit = Revenue – Direct Operating Costs

If we deduct the Indirect Operating Costs from the Gross Profit, we arrive at the Operating Income (EBIT).

Operating Income = Gross Profit – Indirect Operating Costs

If we deduct the Cost of debt finance and Tax from the Operating Income, we arrive at the Net Income.

Net Income = Operating Income – (Cost of debt finance + Tax)

Hint: If we take the gross profit and divide it by the revenue, we get the gross profit margin. The gross profit margin provides an indication of the companies financial health by calculating the money that is left over after subtracting the cost of goods sold from the product sales. This can be used by analysts to compare two companies that are producing the same product, to see which one of the companies has the higher profit margin. A company with a higher profit margin might be more efficient because it has lower costs to produce the same product.


Balance Sheet vs. Income Statement

You might ask yourself, why we actually need the income statement, if we have all covered under retained earnings. The answer is, that we could record all on the Balance Sheet, but it would be rather cluttered and impractical. This is why it makes sense to have all the details on the income statement, and only have one line called “Retained Earnings” in the Shareholder Equity section on the balance sheet, that is equal to the “Net Profit” on the Income Statement.

  • The income statement shows the revenues and expenses of a company and its profitability.  The net profit (or loss) will go onto the retained earnings section on the balance sheet (Retained Earnings is equal to Net Profit).
  • On the balance sheet, only the “Retained Earnings” number is required in the “Shareholder Equity” section, which is equal to the “Net profit” (or loss) on the income statement.
  • Details such as Revenues, Cost of sales, Salaries, Interest, and Tax, are optional on the balance sheet.

Balance Sheet Extract

Shareholder Equity
Common Stock

100
Retained Earnings
Revenues
Cost of sales
Salaries
Interest
Tax
16
100
(50)
(30)
(4)
(0)

Income Statement Extract

Revenues
Cost of Sales
100
(50)
Gross Profit
SG&A Expenses
50
30
Operating Profit
Interest expenses
Tax
20
(4)
(0)
Net Profit16

Recording income and expenses

In order to record income and expenses, we need to take a closer look how to deal with Prepayments, Accruals, and Depreciation.

Another important point to note is, that the income statement only includes revenues and expenses that relate to the relevant accounting year.

Prepayments (Expense)

If we do any prepayments, for example for insurance, the costs for prepaid expenses are smoothed out over the period of the runtime on the income statement.

Lets take a look at an example:

Let’s assume that an insurance has been purchased with a start date of December for 12 months costing $24’000.

The costs have been prepaid, so the cash position on the balance sheet has been deducted by the full amount of $24’000.

In order to smooth the costs out over the period, we calculate the monthly costs: $

$24’000 / 12 months = $2’000 per month

As the insurance started in December, we record $2’000 (one month) as an indirect expense on the income statement (under indirect operating costs).

The other 11 months of $22’000 are recorded as a prepaid expense on the balance sheet under current assets because the duration is a year.

If the duration would be over a year, then it would be recorded under non-current assets.

 

Accrued expenses

Accrued expenses are expenses, that will become due at some point, but are not yet paid.

Let’s take a look at an example:

Let’s assume that the company ordered and used $4’000 of office supplies, but they are not paid until the following year.

This will be recorded as an accrued expense under current liabilities on the balance sheet, as the $4’000 will be paid within under a year.

If the expense would not be paid over a year, it would be recorded under non-current liabilities.

Accrued expenses will be reflected on the income statement, even though they were not yet paid for.

Examples

Let’s have a look at a few examples of how to record transactions between the balance sheet and the income statement. Let’s assume a company needs to record 3 transactions on the year-end of 2019:

Transaction 1 – Purchase of one year insurance

Purchased one-year insurance for $12’000 in November 2019.

The full payment of $12’000 was made on November 1, so there is a credit in cash on the balance sheet of $12’000. The actual expenses will incur monthly ($12’000/12 = $1’000), as the costs are smoothed out over the year. On Dec 31, 2019, a total of $2’000 ($1’000 for Nov + Dec 2019) is shown on the income statement as a debit. The other $10’000 is recorded on the balance sheet as a prepaid expense.

PositionDebitCredit
Insurance expense (Income Statement)$2’000
Cash (Balance Sheet)$12’000
Prepayment (Balance Sheet)$10’000
Accruals (Balance Sheet)
$12’000$12’000

Transaction 2 – Interest expense

Paid $2’500 of interest expense on January 1st, 2020 (interest to be paid monthly for outstanding loans as of December 2019).

The $2’500 was due on Dec 31 2019. However the payment has not been done until January 1st 2020. Thus an expense was incurred and accrued. So on Dec 31 2019 $2’500 was debited from the income statement, but because the expense wasn’t paid yet, it went under “Accrued Expenses” on the balance sheet.

PositionDebitCredit
Interest Expense (Income Statement)$2’500
Cash (Balance Sheet)
Prepayment
Accrued Expense (Balance sheet)$2’500
$2’500$2’500

Transaction 3 – Sold consulting contract

Sold a training contract to be delivered in January 2020. The training fee is $4’000 which will be payable 30 days after the work has been completed. There is also a development fee of $6’000, payable at the same time as the course fee. The development will be carried out in December 2019 and January 2020 with an equal amount of work.

The consulting fee of $4’000 is only payable after the completion of the work in 2020. So no revenue has incurred on Dec 31, 2019. The development fee however is incurred monthly ($6’000 / 2 = $3’000 per month). As one month of work was done in December 2019, there is a $3’000 revenue shown on the income statement, which is accrued on the balance sheet under “Accrued Income” as the payment will only happen in 2021, once the course completed.

PositionDebitCredit
Revenue (Income Statement)$3’000
Cash (Balance Sheet)
Prepayment (Balance Sheet)
Accrued Income (Balance Sheet)$3’000
$3’000$3’000

Depreciation

There is equipment that we buy (usually under non-current assets), which depreciates over time. For example, computers, or machines, which will be outdated, or wear down over time. These are called depreciating assets, as these items lose value over time.

There are 3 different methods how the assets can be depreciated:

  • Straight line approach
  • Double declining balance approach
  • Units of production approach

Straight line approach

Let’s assume that we purchased laptops that have a 4 year lifetime for $80’000. Once the 4 years are over, the equipment will have a scrap value of $30’000.

When using the straight-line approach we will deduct the same amount every year, down to a scrap value:

Depreciation per year = (Cost – Salvage value / Useful life of asset)

Depreciation per year = ($80’000 – $30’000) / 4 = $12’500

On the balance sheet, we will take the purchase price, and deduct the depreciation price from it, which then in the first year leads to a closing balance of 67’500 for the Property Plant and Equipment asset (first, the $80’000 are recorded but at the end of the year, the 12’500 are deducted).

In the second year we take the $67’500 worth of equipment, and again deduct 12’500 depreciation expense from it, which will then be $55’000 in the second year.

Depreciation per year: ($80’000 – $30’000) / 4 = $12’500

PP&E 1st year = $80’000 – $12’500 = $67’500

PP&E 2nd year = $67’500 – $12’500 = $55’000

PP&E 3rd year = $55’000 – $12’500 = $42’500

PP&E 4th year = $42’500 – $12’500 = $30’000

After the 4 years, the laptops stay on the book with $30’000 until they are sold (for whatever value) or disposed.

In summary each year, from the year of purchase, the same amount will be deducted, until the scrap value is reached.

Double Declining Balance approach

With this method, the depreciation is greater in the first few years and smaller in the later years. This can be useful to lower the tax bill during the first few years.

Depreciation per year = ((100% / Useful life of asset) * 2) * Beginning period book value

(1/ asset life) * 2 * beginning period book value

Units of production approach

The depreciation varies each year and is based on the output that the assets produce. This is useful if machinery is used, that will wear and tear based on the number of assets that are produced.

Depreciation per year = (# of units produced / Lifetime # of units) * (Cost – Salvage value)

Chris

Chris is an IT Project Portfolio Manager within the financial industry. Due to the nature of his role, he is engaged to study Financial Markets and is an active investor.

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