Income Statement: Components and Steps

“The Profit and Loss Statement tells you a lot about how your business is doing. It can also help you to determine ways that you can go about saving money so that you get to bring more money home,”

-Darren L Johnson

 

What is an Income Statement?

 

Income Statement aka Profit and Loss Statement , Earning Statement or the Statement of Operations shows the revenues and expenses of a company. It depicts if a company makes profit or loss in a given period. 

 

It is a part of financial statements of a company that includes balance sheet, cashflows etc. Interpreting the income statement helps us to understand the profitability and financial health of a company. 

 

Usually, companies compare current statements with past statements to analyze the deviations. The income statement is prepared by the accounting professionals because it involves compiling huge volumes of data. 

 

Income statement tells us if profits can be increased by reducing the costs or increasing the revenues. The effect of business strategies is shown in the financial statement in terms of profits generated. 

 

So, if the profits earned at the end are what the company desired then its strategies have paid well. Otherwise companies have to rethink and replan the strategies. Here are three benefits that income statement has apart from showing profits:

 

1. Frequency of Reports

 

Most financial statements like balance sheets are prepared on a yearly basis. But the income statement can be prepared monthly, annually, semi-annually, quarterly. Weekly preparation is also possible in the case of very small businesses. 

 

This way companies can easily find out any omissions or errors in the accounting or recording. Problems can be identified early so that heavy expenses or frauds do not arise later on.

 

2. Shows the Expenses

 

The income statement helps to point out the expenses that the company has incurred. To find out overspending or underspending we can easily trace the income statement. All small expenses like rent and overheads and big expenses salaries are recorded in the income statement. 

 

As the business grows, more expenses are incurred and the income statement shows all of them. Therefore, an income statement is extremely useful in showing the expenses properly and accurately.

 

3. Helps in Analyses

 

Income Statement is very useful for the stakeholders like banks and FI. It helps them decide whether a company should be given loans or not. So, for outsiders, an income statement offers knowledge about the financial health of the company.

 

Talking about the users of income statements, we can divide stakeholders into 2 categories. One is external and the other is internal. External stakeholders are the investors, competitors and creditors. All three of these have different reasons for checking the income statement. 

 

Like creditors have to see whether a company has enough funds to set off its liabilities and borrowings. Investors check if the company has any growth prospects in future. Competitors check what new technologies and profits companies are making and what they can implement themselves. This is usually done as a part of environment scanning. 

 

Internal stakeholders on the other hand are the board and management. Both these have to analyze the income statement to check if the business is profitable enough based on the current strategic planning. 

 

They have to check the sources of revenue, expenses, and find deviations from the actual budget they made. Therefore, the income statement is a very useful part of a financial statement. 

 

Components of the Income Statement

 

“Year-end financial statements ... express a truth about office life which is no less irrefutable yet also, in the end, no less irrelevant or irritating than an evolutionary biologist's proud reminder that the purpose of existence lies in the propagation of our genes.”

- Alain de Botton

 

When we make an income statement there is no distinction between the cash and non-cash items. There is a fixed sequence that is followed. First the focus is on all the revenue generating items. Then on the expenses, operating expenses and finally on gains and losses. 

 

So, it is evident to say that there are 4 main elements of the Income Statement that are mentioned below:

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Components of an Income Statement

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1. Revenues

 

Revenues can be operating or non-operating. Operating revenues are generated from the primary activity of the business. For example- selling products is the primary revenue generating activity for a manufacturing firm. 

 

On the other hand, non-operating revenues are generated from other activities. For example- rental income, sale of scrap, sale of any asset, royalty of any other income from secondary sources. Revenues are very important as every investor will look at the revenue of the company before investing any amount.

 

2. Expenses

 

Just like revenue, expenses are also of 2 types- Primary and secondary. Primary expenses are linked to the main activity of the business. For a manufacturing company, primary expenses will be expenses that are linked to manufacturing. 

 

Secondary expenses on the other hand are related to other activities like paying rent of premise, office expense, travel expenses, purchasing an asset, paying compensations.

 

3. Gains

 

Gains are the money that you make from other sources. For example- Your company had an old car. You sold at a price greater than its written down value. So, the additional amount you got on the sale will be treated as your gain. 

 

It is also reflected in the income statement. Similarly if a company sells its subsidiary or piece of land, then also we will call the additional amount made as gain.

 

4. Losses

 

Just like gains, losses are the opposite. If you sold the car below the written down value, then it's a loss. Similarly for selling the subsidiary or land. Losses are also shown in the income statement. Losing any legal case and paying a heavy compensation or a fine is also a type of loss.

 

Also Read | What is PPE?

 

Steps to make an Income Statement

 

Given below are the steps using which you can make a simple income statement. There are in total 8 steps to make an Income Statement which are:

 

1. Choose the Relevant Accounting Period

 

The first is to choose an accounting period for which you will make the income statement. The period should be chosen carefully as all the computation will be done based on that period. 

 

Usually, the income statement is prepared monthly, semi-annually as well as annually. But there is no restriction as such. If you want to go for a shorter period to make some adjustments then you can do that too. Annual and quarterly statements are prepared to see the long term financial position of the company.

 

2. Computation of Total Revenue

 

After the accounting period is decided, all the revenues during that period should be calculated and added. Revenue means the income generated by a company in a particular period. 

 

Basically, the business has to decide if they want to make a consolidated statement or a separate statement of a particular segment. Based on it all the revenues must be calculated.

 

3. Compute the Cost of Goods Sold (COGS)

 

Cost of Goods sold means the total cost that is related to the final good that a business manufactures and sells. 

 

It includes the labor expense, material expense, distribution expenses, cost of any part or any cost which was directly related to the manufacturing of the product. After the revenues are calculated, it is time to calculate the COGS of the relevant accounting period. 

 

4. Computation of Gross Profit

 

Computing gross profit is very simple. You just have to subtract all the expenses calculated in step 3 from the revenues of a particular period.

 

5. Calculation of Operating Expenses

 

After Gross profit is computed, it is time to calculate all the operating expenses. Like all direct costs were included in the Cost of goods sold. Operating expenses include all the indirect costs related to the product. 

 

Examples of operating expenses are- rent, indirect overheads, legal feels and cost of office supplies etc.

 

6. Find the Earnings Before Interest & Tax (EBIT)

 

In order to compute the profit before interest and taxes, we have to reduce all the operating expenses from the gross profit. We can say that the profit you get after reducing operating expenses, is your profit before taxes. So majorly you have to pay taxes from it. In short, it is called EBIT or PBIT.

 

7. Computation of Interest and Taxes

 

Once Earnings before Interest and Taxes is computed, the next step is to calculate the interest and taxes. Interest is the charge you have to pay on debt. To compute interest you need to know the amount borrowed and the rate at which interest is charged. 

 

Then calculate the interest amount. For example- If the debt is $10,000 @ 10% per annum. Then interest will be- $10,000*10%=$1,000, how much interest is due will depend on the time period. If the statement is made annually then $1000. 

 

Otherwise, proportionate interest will be calculated. Nowadays, computers and softwares calculate interest very easily with the data. After interest, calculate taxes. They can be statewise, central or local. It depends on the country in which you live, as the tax regime is different globally.

 

8. Compute the Net Income

 

The last and the final step of preparing the income statement is to compute Net Income (NI). To find NI, we subtract the interest and taxes computed from in the step before from the earnings before interest and taxes. 

 

The amount of Net Income is the total funds you have in your business after everything is settled. This amount can be transferred to reserves or used for R&D or even distributed to shareholders.

 

Also Read | Introduction to EBITDA

 

Every type of business big or small has to prepare an income statement. It is usually prepared by accounting professionals or experts in the said field. Every business has to excel in compiling data for making the income statement. 

 

It is a relevant skill that every account manager must have. This statement is so useful from an external point of view as well. So, the income statement must be true, fair and reliable in every way