What is an Income Statement?
An income statement is a formal way of collating and quantifying all business incomes and
expenses for a specific period of time (usually a year) to gauge whether that period was
profitable or not.
The reason most entrepreneurs choose to start up their own business is to make a profit
eventually. But what exactly does profit mean? To put it simply, profit is what you get after you
take out all your expenses from all of your revenues and still have money left over.
No matter what industry your business operates in, there are certain standard ways of making
money. These are known as “income” streams and can include accounts such as sales revenue
and service revenue. Whatever receipts you have from your primary business output is included
in this definition.
All businesses incur certain expenses as well that come with operating and financing that
business. These “expenses” can differ for each firm and industry, but some common ones are
salaries and wages expense, rent expense, office supplies expense, insurance expense, and
insurance expense. These are the payments that a business makes to keep producing and selling
its primary business output.
A business might see periods of time where their income is greater than their expenses, and those
periods are characterized as periods of “net profit.” However, it is equally possible to be in a
financial situation where your expenses are greater than your income, and in that situation, you
would be in a “net loss” scenario.
An income statement is a financial document that adds up all the income and expenses for a
particular period of time (usually a year) and then subtracts them to show whether the business
made money (profit) or lost money (loss).
Income statements are incredibly important for a business because they are one of the primary
financial documents used by external agents to assess the company’s current and future
performance. Investors use the income statement to gauge how they feel about the future
profitability of a firm as this directly relates to their share price. If the firm’s income statement
shows a profit, then investors will be attracted to invest their money in that firm in hopes of
higher future returns.
Creditors and lending agencies such as banks also use the income statement to predict whether
the company will be profitable enough in the future to pay off their dues or not.
A typical multi-step income statement is divided into two sections: gross profit and net profit.
Gross profit is the money left over after the costs of the primary business activity (producing or
purchasing goods) are subtracted from the revenues of the primary business activity. In this
stage, an average income statement would show “net sales” that is sales less any discounts and
sales returns. Net sales would then be used to finance the “cost of goods sold.” This is simply all
the direct costs associated with producing or buying the items sold, such as the cost of raw
materials or direct labor working on the product.
Net profit is what is left of gross profit after you take out all other operating expenses such as
advertising and insurance expense etc. This is also where you would add any additional revenues
such as interest revenue or any gains on the sale of business assets.
Getting an accurate net profit figure is the ultimate goal of any income statement as net profit is
the real profit used by internal and external agents of the business to assess the overall business
productivity.