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What is an income statement and why is it essential for business?

In general, resources, operations, or marketing management are the direct factors of any company's performance. But what about financial management?

It is the factor that when you do it right, you can achieve business success. In finance management, you reply to some reports and statements that make you fully aware of your finances. For example, when you have a company's annual reports, there is a special section for the financial statements and clarifications complementing them among the branches.

What is the income statement?

  • Income statement: This statement identifies revenues, expenses, and net profit during a specific period.

  • Financial position statement also known as balance sheet, expresses the position of assets, liabilities, and property rights at a specific time.

  • Cash Flow List It shows the movement of incoming and outgoing cash flows during the specified period.

  • List of Changes in Equity It shows the movement and operations on the equity section of the statement of financial position.

To learn the basic principles of accounting, read the article: Financial accounting basics and principles for beginners

We will start with the income statement and review its components and purpose.

Components of Income Statement

The income statement is the primary indicator for measuring the company's performance, and it consists of the following elements:

  • Revenues from which the cost of sales is deducted to produce your total profit margin. The total profit margin is deducted from the operating expenses, resulting in an operating profit.

  • Then, non-operating expenses are deducted from the operating profit to have the net profit.

Income list formula

Revenue - Cost of Sales = Gross Profit Margin

Gross profit margin - operating expenses = operating profit

Operating profit - non-operating expenses = net profit

Here are the details of these items:

Revenues:

Revenue is the gains generated from selling the company’s main product or service, which matters to the investor. For example, Apple generates revenue from selling iPhones, Macs, and iPads, and Uber achieves sales from passenger-to-driver service and freight services through its platform.

These revenues should not include any payments that are not related to the company's main activity, such as the return on deposits, because the investor measures the efficiency of the company's business model in making profits and the strength and competitive advantage of the product or service from the revenue number.

Sales cost:

It is called the cost of sales in the case of trading companies or companies that provide services, such as Uber, and it is called cost of goods sold in the case of industrial companies like Apple.

Whether the cost of sales or cost of goods sold, this item includes costs directly related to sales/revenue, like wages for workers and the cost of raw materials used to manufacture iPhones. Or in Uber's example, the cost of providing services, expenses for maintaining and securing the platform or application, and expenses necessary to process payments made on the Uber application.

Gross Profit Margin:

After deducting the cost of sales from the revenues, the total profit margin is generated. It shows the investor of the company’s profit from selling the product or providing the service. For example, if it was $10, then this means that the company earns $10 from each product.

Operating Expenses:

They are the expenses necessary to operate the company and manage the sale of the product or service but not directly related to sales, such as general and administrative expenses, selling expenses, depreciation, research and development expenses, and others.

These expenses are costs associated with the company's main activity and are necessary to manage and sell the main product or service provided by the company.

Operating Profit:

Operating profit coming from deducting operating expenses from the total profit margin. This profit is considered the one that measures the company's performance and will be repeated in the future because it results from the company's main activity. When you read the income statement, do not let anything distract you from this profit.

Non-Operating Expenses/Losses/Revenue:

This item includes all expenses/losses/returns that are not directly related to the company's main activity, such as restructuring expenses, losses or returns resulting from the sale of some assets. These items are non-recurring and, therefore should not be relied upon when evaluating the company's performance.

Profit before interest and taxes:

After deducting non-operating expenses, losses, and returns from the operating profit, you will have profit before removing interest and taxes. For your information, interest and taxes are from non-operating expenses, but they are separated to see the company’s ability to pay them, as they are among the costs that must be paid according to the law and contractual obligations.

Net profit:

Net profit is the outcome of the above points, which is what the shareholders will have at the end of the year. The company’s management decides if this profit will be distributed to the shareholders as dividends or/and goes to retained earnings in the balance sheet.

At the bottom of the list, you will find an indicator called the share of profit per share, dividing the net profit by the number of shares, and the share of profit per share does not mean that the shareholder will get it. Still, this is the shareholder’s share if the company’s management agrees to distribute all profits.

Purpose and Uses of Income Statement:

Also called profit or loss statement, income and expense statement, its purpose is:

It informs the reader or investor of the company's performance over a period, whether annual or quarterly. To know how the company's business model works. In this list, you will find the revenues, expenses, profits, and losses that occurred during a specific period, usually a year, unlike the financial position list, which expresses the company's financial position at a particular time.

  • Income statement shows whether a company is making a profit or loss and what items led to this. For example, in the case of technology companies, you can know the extent of the company's interest in research and development through the item of research and development expenses in the income statement.

  • Also, by comparing the numbers of this list over the previous years, you can know whether sales and revenues are growing, declining, or stable, as well as measure the efficiency and ability of the company's management to control expenses by reducing and rationalizing them.

  • If you are a creditor to the company, for example, a bank, it is advised to rely only partially on this list because it tells you about the past, not the future. Because not all profits are in the form of cash, and being a creditor to the company, what matters to you is the future cash flows through which the company can Pay off debts, so here you must use the statement of financial position and the list of cash flows.

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