Income statement: Understand the basics

You don't need to be a CA or a CPA to understand one of the essential and important financial statements found in a company's annual report and in other such filings: the income statement.

But why should you understand an income statement of a company? Well, as an investor, understanding the fundamentals of the income statement will help you take an informed decision before buying new stocks. Here we help you understand the income statement, its basics, what do they tell the investor and how to figure it out.

What is an income statement?

In a nutshell, the income statements of a company show you how much money the company has made and how it has been spent. In other words, the income statement shows how much revenues the company has made and how much expenses it has met during the particular period of the year or for the entire year. This includes the costs and expenses that were incurred to make the revenue.

The difference between the two, the revenues and expenses, determines the company's profit or loss. Simple logic could explain that if the company's revenues are more than the expenses then it is profit for the company and if the expenses exceed the revenues then it is loss for the company.

Generally, the income statement is released either every quarter or half yearly or every year. Usually, the income statement is also released through the press apart from the financial/annual reports of the company.

Some of the key things that you will find in the income statement are the total revenues, net income or earnings per share or EPS. For a shareholder the EPS is important as this will be the share of the company's net earnings that he will take home. However, most companies do not distribute all of their earnings but instead reinvest them in the business.

The income statement is more like a direct answer to the health and financial status of the company. Every investor would like to invest in companies that incur low expenses relative to revenues and consequently post higher profits relative to revenues. Every shareholder is thus benefitted from investing in companies with healthy financial status.

What is revenue?

The revenues section is perhaps the simplest part of the company's income statement. Revenues are commonly known as sales and are the total money given as a single figure. It is the amount the company has made through various avenues during a particular period. However, some companies, if operating from many countries or across many segments, might give many figures which will be primarily the breakdown of revenues to provide more information.

What are expenses?

A company might incur many types of expenses however the most common of them all are the cost of sales and selling, general and administrative expenses or SG&A.

Let us see what cost of sales mean. Also called cost of goods sold, cost of sales is the most direct expense involved in generating revenue. For instance, if a company makes a shirt for Rs100 and sells it for Rs 150 then the cost of sales for the company in making that shirt is Rs 100.

Operating expenses are the costs involved in selling, general and administrative expenses like marketing, salaries and technology among others as incurred by the company.

What are profits?

Profit is arrived at by deducting the total expenses from the total revenues. This is the simplest form of profit calculation. However, there are many other profit subcategories used in the business world such as gross profit, operating profit and net income.

The company's gross profit is calculated as the revenue less the cost of sales. And this money that is got is the amount that is spent on operating expenses after the sales. This should typically mean profits to shareholders.

In our above example of a shirt, the gross profit from the sale of shirt is Rs 50 (Rs150 is the sales price minus Rs 100 towards cost of sales).

The operating profit is the revenues made after deducting the cost of sales and sales, general and administrative expenses that include marketing expenses, salaries and other expenses that are not directly linked to the company's actual operations.

The net income of a company is the revenue minus all expenses including everything related to the company's operations. This is otherwise called the profit or earnings.