The income statement offers an overview of a company’s performance over a specific period. It is perhaps the most widely used financial statements by different users, including managers, shareholders, and investors.
The income statement reveals how much a company earned during the year, spending, tax, interest, and net profits.
It also reveals how much profits a company retains and how much is distributed to the shareholders.
Let us discuss our top 7 uses of the income statement.
What is an Income Statement?
The income statement is a company’s financial report that shows its profit and loss over a specific period, usually a year.
The income statement shows the revenue generated and expenses incurred by a company. The difference between the revenue and expenses is the profit for shareholders.
Analyzing an income statement can provide further information. Each line item in the income statement offers insights into a company’s specific segment performance.
Major line items included in a typical income statement include the following.
- Revenue or Sales
- Cost of Goods Sold
- Gross Profit
- Operating Expenses
- Operating Profit
- Taxes, Interest, and Depreciation Costs
- Net Profits
- Earnings Per Share
What are the Top 7 Uses of the Income Statement?
Analysis of each line item can offer further information about a company’s performance. Analysts can use several tools to extract valuable information.
1) Profitability Analysis
Profit is the bottom line of any business. An income statement includes gross profit and net profit figures. Both these figures are important for shareholders, along with the earnings per share.
Analyzing profit figures as standalone dollar values does not offer much. The prime purpose of an income statement is to offer insights into these figures. Thus, digging deeper can reveals further information.
The revenue figure shows the sales volume of a company. The cost of goods sold shows the direct costs to sell these products/services.
Similarly, operating costs offer insights into the indirect expenses such as a business’s administrative and research and development costs.
The profitability figures can be used to perform the trend analysis as well. These figures can be compared with the company’s historical performance to see whether a company is going in the right direction.
2) Operating Efficiency
The profitability of a company is directly linked to its operating efficiency. An income statement can be used for operating efficiency analysis purposes as well.
It is a common scenario to observe a company’s large gross profit figures. However, the same income statement would show small net profits or even net operating losses.
That’s primarily because of the large operating expenses a company incurs.
Analyzing operating costs can also provide information about a company’s operational efficiency. For instance, if a company keeps its direct costs at a targeted level but its operational costs are higher, it will incur net operating losses.
Operating costs include administrative, salaries, and research and development costs. Some companies must invest heavily in the R&D section to maintain their competitive advantage.
3) Non-Operating Income and Cost Analysis
A major portion of operating costs includes the administrative costs of a business. On the other hand, non-operating costs also make up a substantial portion of a company’s total costs.
Non-operating costs reduce the net profits of a company.
Business managers are particularly interested in analyzing non-operating costs. For instance, a company financed heavily with debt will keep an eye on its interest costs.
Lenders will also be keen on analyzing a company’s strength to make interest payments on time.
Similarly, many activities of a business can incur high non-operating costs. These costs may include restructuring, replacement costs of obsolete inventory, and reorganization costs.
The income statement is also used to analyze the company’s non-operating income. The non-operating income sources include income from investing activities such as banks, bonds, or other investments.
4) Tax, Interest, and Depreciation Analysis
The income statement includes a company’s tax and interest obligations. Depreciation and amortization are non-cash items. These items are then carried to the cash flow statement to analyze the company’s actual cash flow.
Business managers must carefully evaluate the depreciation costs as these are non-cash items. Unrealistic estimates of depreciation costs can lead to false net profit analysis.
Analysts often use the Earnings Before Interest, Tax, Depreciation, and Amortization figures instead of gross profits.
The purpose of using the EBTIDA figures is to easily assess the non-cash items such as depreciation and amortization.
5) Earnings for Shareholders
The distributable income for shareholders is the figure after tax and interest costs profit. It is a company’s net income that it can distribute in the form of dividends or retain for future growth.
The dividend decision is important for the company to satisfy the shareholders. Shareholders and investors can analyze the earnings per share from the net income figure on the income statement.
The section below net income also includes income from other sources. These sources may include income from non-controlling interests in other companies.
Similarly, any income from discontinued operations is also included in this section.
Though it’s not mandatory, many income statements include the figure of a company’s outstanding shares. The total outstanding shares will include convertible debt, preference, and common shares.
Shareholders can also calculate the EPS and price per earnings ratios directly from the net income figures.
6) Risk and Growth Analysis
An important purpose that income statements (and other financial statements) serve is to help analyze the risk and growth of a company.
For instance, the interest costs and the debt liabilities can help analysts assess a company’s leverage status.
Similarly, the trends analysis on operating profits or net profits can reveal much information about a company’s growth prospects.
Business managers can evaluate the income statement line-by-line profitability and risk factors. For instance, if a company generates lower sales consistently, it will face severe liquidity and profitability issues.
7) Compliance with Regulatory Requirements
One of the main purposes an income statement serves is compliance with statutory requirements. Listed companies are required by law to produce financial statements.
Although non-listed companies do not need to publish their financial statements, they must also produce them.
The income statement is one of the three major financial statements required by regulatory authorities and the balance sheet and cash flow statement.
All businesses must follow standard accounting practices as well. Producing financial statements also ensures a company is complying with accounting standards as well as regulatory requirements. Businesses either follow the US GAAP or the IFRS accounting standards.
8) Putting it Together
The income statement provides static and historical figures about a company’s performance over a specific period. However, it serves many purposes other than stating figures in dollar amounts.
An important point to remember here is that no standalone figure can reveal the full picture of a company’s financial performance.
Analysts of the income statement must put all pieces of information together to draw realistic conclusions.
Although the income statements include historical figures, they can provide useful information about its future performance.
Business managers and external analysts can use ratio, trend, and risk analysis to conclude a company’s performance.