We recently wrapped up our two-part piece on balance sheets, and today we are going to move on and start taking a look at the next financial statement on our list, the income statement, also called a “profit and Loss Statement”. Unlike the balance sheet, which looks at a company’s financial position at a specific moment in time, the income statement reflects performance during a period of time, typically a calendar year or quarter. Let’s continue with our fictitious ABC Corporation and have a look at its income statement below.
ABC Corp. Income Statement Dec. 31, 2010
|Cost of Goods Sold (COGS)||$60,000|
|Research & Development (R&D)||$5,000|
|Selling, General and Administrative Expenses (SG&A)||$45,000|
|Earnings Before Interest & Taxes (EBIT)||$40,000|
As with our sample balance sheet, your company’s income statement will not look exactly like this one (it may be missing some of our entries and contain some additional line items), but it should follow the same general pattern. It will start with a figure labeled total revenue or perhaps net sales—which is essentially the same thing—at the top, and then break down various expenses before concluding with a net income (or loss) figure on the bottom line. This is why people often refer to a company’s profitability as “the bottom line”.
Let’s go through ABC’s example line by line and see if we can start to get an understanding of some of the major items that you can except to see on an income statement.
Total Revenue (or Net Sales) – This is pretty straightforward; the figure represents the total amount of money that the business brought in for the period covered by the income statement. If the company has any other income streams, they will also be listed, such as interest income, income from investments, or other income.
Cost of Goods Sold (COGS) – COGS tells us how much money we spent to acquire and produce the goods that we sold to generate the revenues included in the line above.
Gross Profit – Is equal to total revenue minus COGS.
The next section of our income statement breaks down a group of costs known as operating expenses, which include things like salaries, office supplies, and other items that are essential to the day-to-day functioning of a business. If an expense can’t be included under COGS (i.e. it is not directly related to the production of a good or service) then it should appear as an operating expense. ABC’s operating expenses are divided into the following two entries.
Research and Development (R&D) – These costs are often thought of as those that pertain to the future of a business, such as the testing and development of a new product or prototype.
Selling, General, and Administrative Expenses (SG&A) – This broad category encompasses all of a firm’s personnel costs (salary, benefits, and the like) as well as things like advertising and travel expenditures. Sometimes these and other like expenses are detailed out as separate line items.
We now move on to the operating income section of the income statement, which in our case contains these four items.
Earnings Before Interest & Taxes (EBIT) – This figure shows us a company’s total profit before accounting for interest and taxes that it has to pay. Although this may not seem like a useful metric, and indeed there are many who argue that it is not, because everyone has to pay taxes and all borrowers must pay interest on their loans, some people find it helpful to isolate a company’s ability to generate profit and to compare similar companies with different tax rates and barrowing habits.
Interest Expense – The amount of money that a company pays as interest on its loans during the period covered by the income statement.
Taxes – We’re all familiar with this one, on the income statement the figure represents the total tax bill for the period and is sometimes expressed as a percentage (i.e. a tax rate) as well as a dollar figure. S-corporations, remember, do not pay taxes, but rather pass the tax liability through to the shareholders.
Net Income – Often referred to as a company’s “bottom line” because of its position on the income statement, net income is what is left over from total revenue after subtracting all expenses.
That brings us to the end of ABC’s statement and of this week’s post. Next week we’ll dive deeper into how to analyze and interpret the income statement.
101: Balance Sheets Part I
101: Balance Sheets Part II
101: Inflation Part 2
101: Supply and Demand Part II