Income Statement is a financial statement that shows the performance of a given organization over a certain period of time.
The main underlying idea behind constructing an Income Statement is to calculate the overall excess of sales revenue, compared to incurred expenses.
However, in addition to serving as an internal performance metric, it can also serve the following purposes, as mentioned below.
- Calculation of Profitability:
During the normal course of the business, there are numerous transactions taking place. As a result, it often becomes hard to keep a perpetual track of the incurred expenses, in comparison to the revenues that the organization has earned.
Therefore, Income Statement simply summarizes these transactions into broader heads, for the users to be able to identify the actual profit (or loss) that have been incurred over the given time period.
- As a Measure of Performance:
The fast-paced environment in the modern-day and age has resulted in organizations struggling to sustain their competitive advantage.
As a result, they are often inclined towards continual improvement. Having an Income Statement makes it easier for them to compare their performance, as compared to the previous year, as well as competing firms.
They are able to set targets for the coming years accordingly, and this greatly helps them to track their performance and strategize accordingly.
- As a Decision-Making Tool:
Income Statement can broadly be categorized into three broad categories. These categories are Revenue, Cost of Sales and Overheads.
Having an Income Statement with these subsequent heads helps the organizations to actually see where the issue lies, and then set their strategies accordingly.
For example, a higher Cost of Sales might be indicative of a need to reduce the purchase price. Similarly, lower Gross Profit also hints towards the need to either increase the Selling Price or reduce the Purchase Price.
Therefore, bifurcation of these subsequent heads can act as very vital towards decision making.
- In order to conduct Ratio Analysis:
Ratio Analysis is a comparison of the line items in the financial statements of the business. Ratio Analysis is integral for a business, not only as a performance metric but also as a pivotal decision-making tool.
Having a consolidated snapshot of revenues and expenses can help organizations draw valuable comparisons between different line items, and point out the factors which can be tweaked in lieu of enabling the company to deliver better results.
- Legal Requirement:
For almost all company types, are supposed to prepare their financial statements. Governments and Company Regulators across the globe are highly inclined towards transparency, and full disclosure, in order to ensure that there are mitigated chances of any fraudulent activity taking place.
Therefore, organizations are supposed to prepare, and turn in their financial statements to justify their earnings, and for computation of tax. For Sole Trader Proprietorships, it is mainly used for computation of Direct Taxes.
However, for bigger companies, the purpose is two-fold, computation of taxes, and prevention of any fraudulent activities from taking place.