What Is a Profit and Loss Statement?
One of the three financial statements that stock investors rely on is the income statement. (The balance sheet and cash flow statement are the other two.) Investors who wish to examine a company’s profitability and potential growth need to know how to read an income statement.
Important Points to Remember:
- The income statement is a financial statement that summarizes a company’s earnings and expenses over a specific time period, such as quarterly or annually.
- There are two types of income statements: multi-step and single-step.
- Four profitability measures are included in the multi-step income statement: gross, operating, pretax, and after tax.
- The income statement, not the cash flow statement, measures profitability.
- The income statement summarizes a company’s quarterly and annual revenues (sales) and expenses for the fiscal year in the context of corporate financial reporting. Investors and analysts are particularly interested in the final net figure and other metrics in the statement.
The Income Statement: An Overview
Income statements are labeled in a variety of ways. The terms “statement of income,” “statement of earnings,” “statement of operations,” and “statement of operational performance” are the most regularly used.
The word P&L, which stands for profit and loss statement, is still used by many professionals, but it is rarely seen in print these days.
The terms “profits,” “earnings,” and “income” are all interchangeable and indicate the same thing.
In financial statements, there are two fundamental formats for the income statement.
|Multi-Step Format||Single-Step Format|
|Net Sales||Net Sales|
|Cost of Sales||Materials and Production|
|Gross Income*||Marketing and Administrative|
|Selling, General and Administrative Expenses (SG&A)||Research and Development Expenses (R&D)|
|Operating Income*||Other Income & Expenses|
|Other Income & Expenses||Pretax Income|
|Net Income (after tax)*||—|
At four crucial points in a company’s operations, the multi-step income statement reveals four metrics of profitability (represented with an asterisk*): gross, operational, pretax, and after-tax.
The gross and operational income statistics are not given in the single-step format. They can be derived from the information provided. Gross income equals sales minus materials and production in this system. The operational income number is obtained by removing marketing, administrative, and research and development (R&D) expenses from gross income.
Investors should remember that revenues are recognized on the income statement only when they are realized—that is, when items are shipped, services are given, and expenses are spent. The flow of accounting events through the income statement in accrual accounting does not always correspond to the actual receipt and disbursement of cash. The income statement, not the cash flow statement, measures profitability.
Accounts on the Income Statement (Multi-Step Format)
The value of a company’s sales of goods and services to its clients is known as net sales (sales or revenue). Although investors are mainly interested in a company’s bottom line (net income), the top line is where the revenue or income process begins. Profit margins on a company’s existing products tend to reach a limit over time that is difficult to surpass. As a result, businesses can often only develop as quickly as their revenues.
Sales costs (cost of goods/products sold (COGS) and service costs): The cost of sales for a manufacturer is the cost of labor, raw materials, and manufacturing overhead utilized in the production of goods. Depreciation expense, while it might be mentioned individually, belongs in the cost of sales. The cost of sales for wholesalers and retailers is simply the purchase price of items utilized for resale. Cost of sales is the cost of services rendered or cost of revenues in service-related organizations.
The difference between net sales and the cost of sales is not a company’s gross profit (gross income or gross margin). In addition, gross profit provides the funds to cover all of the company’s other costs. Obviously, the higher and more consistent a company’s gross margin is, the better the chances of a good bottom line (net income).
Expenses for selling, general, and administrative work: This is the company’s operational expenses, often known as SG&A. Management is thought to have a lot of influence over this expense category, according to financial analysts. The trend in SG&A spending as a percentage of sales is regularly monitored in order to spot signals of managerial efficiency, or lack thereof.
Operating income is calculated by subtracting SG&A from a company’s gross profit. This statistic shows a company’s earnings before non-operating income and costs such as interest expense, taxes, and special items. Financial analysts frequently use operational income as a measure of profitability rather than net income since it is considered more trustworthy.
The cost of a company’s borrowings is reflected in interest expenditure. Companies may record a net figure for interest expense and interest revenue from invested funds in this section.
Earnings before income tax expense are a key bullet in the income statement and are another closely studied measure of success. Companies have a variety of options for avoiding or minimizing taxes that affect their reported income. Analysts may choose to consider pretax income as a more realistic indicator of corporate profitability because these acts are not part of a company’s commercial operations.
Taxes on income As previously stated, the income tax amount has not been paid. This is a calculation or account that has been set up to cover the amount of taxes that a firm anticipates to pay.
Special items or out-of-the-ordinary expenses: A variety of situations might result in income charges. Restructuring expenses, unusual or nonrecurring items, and discontinued operations are common examples. These are designed to be one-time write-offs. When comparing year-over-year profits, investors must account for these non-recurring items, as they might skew results.
The bottom line (also known as net profit or net earnings) is the most widely used indicator of a company’s profitability. This account caption will read as a net loss if expenses exceed income. Net income is included in a company’s equity position as retained earnings after any preferred dividends are paid. Additional information is provided for net income based on outstanding shares (basic) and the prospective conversion of stock options, warrants, and other securities (diluted).
Comprehensive income is a relatively new notion that takes into account the effects of items like foreign currency translation adjustments, minimum pension responsibility adjustments, and unrealized gains/losses on certain debt and equity investments. The net income figure continues to be the focus of the financial community. The adjustment components are all related to economic factors that are beyond a company’s control. Their influence is palpable, but it tends to dissipate over time.