Financial Statements: How to Read an Income Statement
For each financial reporting period, the income statement shows the money spent by the business and the money earned. It is also called the P&L, Profit and Loss, statement.
Parts of an Income Statement
The income statement lines out the different revenue items and the expenses involved in the business. The parts of the statement includei:
- Revenue – This is the income received from sales of goods and services; it is all the money received as business income. This is before any expenses are considered.
- COGS, Cost of Goods Sold – For retail type businesses, this is usually the wholesale cost of products. It can also be the cost of goods and materials used in the production of items for sale. For a service business, this would include direct labor.
- Salaries/Wages – This is money paid to employees.
- General Expenses – Expenses incurred in the operation of the business.
- Fixed Expenses – These are expenses incurred to operate the business that are the same each month. This would include rent or mortgage payments as well as any debt payments.
- Variable Expenses – These expenses vary each month or payment period. Included in these would be utilities, other variable overhead expenses, and office supplies.
- Operating Earnings (Gross Profit) – This is the gross profit of the business considering EBITDA (Expenses Before Interest, Taxes, Depreciation, and Amortization). Operating earnings show the true nature of money made from business operations alone, before considering EBITDA.
- EBITDA Payments – Those interest, taxes, depreciation, and amortization expenses to be subtracted from operating earnings.
- Net Profit – This is the bottom-line profit of the business after deducting all the expenses, including EBITDA, from revenue.
There are three key financial ratios used in the analysis of the income statementii.
- Gross Profit Margin – The gross profit margin ratio gives you the operating profit picture for the business. It only considers the cost of goods sold and direct costs of production and delivery of the products or services, including direct labor. In other words, what is your profit for just the production and delivery of goods and services.
Gross Profit Margin = (Revenue – COGS) / Revenue
This ratio gives an immediate measure of how efficiently the business produces and delivers their products and services before overhead expenses.
- Operating Profit Margin – This ratio considers the other expenses involved in operating the business, including overhead expenses. However, it is EBITDA, Earnings Before Interest, Taxes, Depreciation, and Amortization.
Operating Profit Margin = Operating Earnings (EBITDA) / Revenue
This ratio, because operating and overhead expenses are included, provides a measure of the performance of the entire operation, not just production direct expense. It provides a measure of income and expense items that can be improved efficiency-wise to increase profits.
- Net Profit Margin – Once all expenses are considered, including the EBITDA expenses, you arrive at the net profit margin.
Net Profit Margin = Net Income / Revenue
This arrives at the actual take-home profit after all expenses involved in the business.
Once you understand the components of the Income Statement, you can scan one and get an immediate picture of how the company’s revenue and expenses look and where there may be room for improvement.
ii Gross, Operating, and Net Profit Margin: What’s the Difference, Investopedia.com