Introduction to Income Statement

Coming to the heart of the matter - financial statement analysis. Since forecasting future earnings is vital to assessing the value of any potential investment, the income statements serve as a vital starting point for most investors. It helps assess and understand the extent and scale of business activities, a company's relative strength and positioning in the market as well as its ability to generate profits.

The income statement is sometimes referred to as the statement of earnings, profit and loss statement, or statement of operations. In its most basic form, an income statement can be summarised as follows:

Revenue - cost = profits

Revenue refers to the amounts reported from the sale of goods and services in a normal course of the business. For example: let’s say we are looking at a company that manufactures motorcycles. Revenue refers to the amount of earnings by selling these motorcycles. If the company sold 1,000 motorcycles at a price ₹1,00,000 each, total revenue earned by the company is ₹10 crores (1,000*1,00,000).

Sometimes revenue is also termed as sales or turnover. Here, we would advise readers to be cautious. Some companies refer to sales as a subset of the revenue. Extending our example above - Let’s say the motorcycle company also sells some spare parts and other allied services. In that case, revenue would mean a sum of both the sale of motorcycles and those allied services.

Although minor, this is just a potential pitfall for investors to know about.

Moving to costs. These are expenses incurred to earn those revenues. The company would have to spend money to buy raw materials like steel, aluminium, plastic, paint, rubber, etc. Beyond this, they would also need to incur ancillary expenses like marketing, office expenses, legal fees and others.

One way to look at costs is to group them by their function.

1. Direct costs: These are directly required to generate your revenue. Think of raw materials in our example. For a services company, it would be manpower. These are called as raw materials of cost of goods sold (COGS)
2. Indirect costs: These are costs that help you run your business but do not help directly generate revenue. In our example, think of the sales and marketing team, or the legal and audit expenses or expenses like rent. While absolutely vital to the smooth functioning of the business, they do directly help produce the motorcycles. Hence, indirect costs.

Finally, the income statement also captures certain other incomes or expenses the firm may incur. In the case of our example, let’s assume the motorcycle company has some cash reserves, which it has invested in debt securities. The interest received from these investments is also an income for the company. Another example can be - the sale of any equipment. If the company sells the equipment, the profit or loss made on that sale, will be reported on the income statement. While both of these are technically income for the company, they are not part of the core operations of the company and so - are classified as other income and expenses in the income statement.

After accounting for all these items, we arrive at the net income or final profit (maybe even loss) the company has made in that particular period.

Let’s look at a very summarised version of the income statement to completely understand this:

_Please note: We have used simple rounded numbers for ease of understanding. _

Here are a few points you must note about representation in the income statement:

1. In the format above, we have shown the main revenue and expenses as positive numbers. As such, the negative ₹50 in the other expense line, implies it is an income and not an expense.
2. The format of choice is entirely the call of the person making the statement. A lot of people represent all costs as negative numbers (show them with minus signs) and keep the income as positive
3. Tip here is: be consistent in your representation and careful in your calculation