When we have discussed the balance sheet , we have looked solely at what the company owns and owes. The income statement looks at what the company earns and pays over the specific time span. While the financial health and a difference in what the firm has and owes to external parties is important, what it earns and how much it must pay for that is equivalently important when making any investment decisions.

The typical income statement starts with the revenues of the company and then provides a breakdown of its expenses sorted by groups with a set of sub headers. The last line of the financial statements is ‘Net Income’; it reflects the amount of money that the company earns after we account all expenses for. Please note, this is not the cash that company makes (we will drill down on cash at a later point when discussing the cash statement), but rather the revenues and expenses that are incurred during the period under accrual accounting.

What is accrual accounting? The accrual method of accounting records revenue when a product or service is delivered to a customer expecting money will be paid in the future. Similarly, the expenses are recorded when incurred, even if there is no cash being paid out yet.

Now we have gone through the basics required to understand the essentials of this exciting financial statement. Let’s get into the various sub headers I have mentioned. To get more practical, you may have a look at recent financials statements of Facebook, BP and Ford that you may see below.

GROSS REVENUES

The gross revenues that we see for all three of examples above are the revenues that are net of cost of goods sold (SOGS). It shows how efficiently the company makes money when we take out the major costs that are attributable to the process of actual creation of the goods sold to the customer. For Facebook, that is the cost of running the platform that is offering the marketing to its customers, for BP that is the cost of oil extraction and delivery and for Ford that is cost of producing cars.

OPERATING INCOME

When we go further down, we see a common line – Operating Income or Earnings before Interest and Taxes (EBIT). This also accounts for all administrative costs of running the business out of Gross Revenues. These expenses typically include sales and marketing, administrative costs, salaries and research and development.

PRETAX INCOME

The next header (Earnings before Taxes, EBT) considers the ongoing interest payments the company incurs in running its business. It is common for the companies to finance its business using debt and most companies would have this kind of expenses.

NET INCOME

Net income is a comprehensive measure of an entity’s income that considers COGS, all expenses, depreciation and amortisation, interest, and taxes for a period. This measure provides us with the understanding of how profitable the company is when all expenses are taken into consideration.

Please note, none of the information on this blog represents the opinion of my employer and all information does not represent a financial advice.