While all financial statements prepared by accountants are connected in some way to profits, the income – or profitability – statement is the one that provides the most details of revenues and expenses and shows profits or losses. While all the financial statements of a business are important and have a distinct purpose, it is the profit and loss statement that gets the most attention. However, a profitability statement can take several forms, and it is essential to understand how they are prepared to make accurate analyses and interpretations.
What Is an Income Statement?
An income statement shows the totals of a company’s revenues and expenses. It matches all revenues from selling goods and services against all expenses – including interest, depreciation and taxes – required to operate the company over a specific time period. These statements can be prepared monthly, quarterly or annually. An income statement has several layers of profitability:
- Gross profits
- Operating profits, or EBITDA (earnings before interest, tax, depreciation and amortization)
- Net income
What Is Gross Profit?
Gross profit is the income derived from manufacturing and selling a product or providing a service. It is calculated by subtracting the cost of goods sold from sales before making deductions for general and administrative expenses. Gross profit margin is calculated by dividing gross profit by sales. It is normally presented as a percentage.
The gross profit margin is a measure of how well a company purchases raw materials and uses its labor force to produce and sell a product. Analysts compare each company’s gross profit margin to other firms in the same industry to determine its competitiveness. Management monitors changes in the gross profit percentage for trends that indicate improving or declining performance.
For example, suppose a company normally reports a gross profit margin of 40 percent, but it increases to 42 percent. What happened? It could be because the company was able to raise selling prices, purchase raw materials at lower prices or use its labor force more productively. All of these occurrences are good. On the other hand, a decline in the gross profit percentage would be cause for alarm, and require management to find the reason for the decline and take corrective actions.
What Are Operating Profits?
Every company has a certain amount of fixed general and administrative costs that are deducted from gross profits to arrive at operating profits. Fixed overhead costs are those expenses that must be paid regardless of the level of sales. They include such fixed expenses as rent for office space, insurance premiums, salaries for administrative staff, and fees for licenses and permits.
Operating profits are another checkpoint to gauge how productively a company is using its assets and controlling its administrative and fixed overhead expenses. Operating profits are calculated before deductions for interest, depreciation, amortization and taxes – frequently referred by the acronym EBITDA.
The primary focus of operating profits is to gauge the performance of a business without regard to its financial structure or tax strategies. For example, a business might have a high gross profit margin and good operating profits, but wind up with a low net profit because the firm borrowed a lot of money and had to pay high interest costs. In this case, the company could be doing a good job of using its assets and controlling costs, but have too much debt to show a good profit.
What Is Net Income?
Net income is the bottom line; it is the profit or losses of a business after deductions for all of the company’s expenses, including costs of goods sold and overhead expenses. Net profit reflects the interest costs from the company’s financing structure and the taxes it incurs from tax planning strategies.
The bottom line profit is the figure that most analysts and stockholders focus on when evaluating the performance of a company. The percentage of net profit is compared to other companies in the same industry to determine its competitive position.
What Are Profit Ratios?
Profitability ratios are valuable metrics used to assess the performance and viability of a business. Ratios produce a more detailed analysis of the quality of profits by expressing specific expenses as percentages of cost of goods sold or sales. Analysts use ratio analysis to look for trends and as a basis of comparison with other companies in the same industry.
What Are the Types of Income Statements?
Accountants prepare several types of income statements, depending on the purpose and the intended audience.
Audited or unaudited: Audited financial statements are prepared by accountants using Generally Accepted Accounting Principles and are considered the most reliable. Audited statements require the CPA firm to express an opinion about the accuracy of the information used in the statements. The three types of opinions are unqualified, qualified and adverse. Banks and other creditors prefer to base their decisions on audited financial statements.
Tax returns: Show the least amount of income to pay the lowest amount of taxes. Income statements for tax returns take advantage of amortization and accelerated depreciation methods that have higher deductions for depreciation and result in lower reported income, thereby requiring less taxes.
Prepared for stockholders: Income statements prepared for the public, analysts and stockholders are structured to present the best possible view of the company.
Management: Statements prepared for management use the most realistic accounting methods. In a sense, financial statements prepared for management are closer to reality than statements prepared for tax returns or stockholders. Management must know that it is looking at reliable and accurate information to make intelligent and informed decisions.
What Does a Balance Sheet Present?
A balance sheet shows the assets and liabilities of a company at a point in time.
While an income statement records a company’s activities over a specific time period, a balance sheet shows the condition and quality of the firm’s assets and liabilities at a certain point. It includes the following assets:
- Cash in banks
- Accounts receivable
- Prepaid expenses
- Real estate
The following liabilities are listed on a balance sheet:
- Accounts payable
- Short-term bank loans
- Accrued expenses
- Long-term debt
- Stockholder capital
- Accumulated retained earnings
How Do Profits Connect to a Company’s Other Financial Statements?
After the accountant tallies up the company’s revenues and expenses, the profit or loss is recorded in the retained earnings section of the balance sheet. Any distributions or dividends from this account are detailed on the Statement of Shareholders’ Equity.
A profit or loss affects the Statement of Cash Flows a little differently. Income statements are usually prepared on the accrual basis of accounting. This means revenues and expenses are recorded as they are incurred, not when cash actually changes hands. Because an income statement contains certain non-cash items, such as depreciation and amortization, the reported profit or loss must be adjusted when preparing a Statement of Cash Flow.
The income statement is the most important report for many analysts. It shows the company’s operating results for an entire year. But, more important, it serves as a guide to anticipate how the company might do in the future. Companies must continuously make a profit over the long term to remain competitive and survive. Profits are essential to finance growth and provide a reasonable return to the shareholders.
Comparing a series of years of income statements horizontally makes it easy to detect positive or negative trends that may need the attention of management to keep performance on the track to achieving long-term growth.