The income statement shows how profitable a company is over a specific period. Also called the profit and loss statement (P&L), it tells you how much money the company made, how much it spent, and what remains as profit. Understanding the income statement is essential for evaluating a company's earning power.
What is an Income Statement?
While the balance sheet is a snapshot at one moment, the income statement covers a period of time - typically a quarter or a year. It answers the fundamental question: Is this company making money?
The Basic Formula: Revenue - Expenses = Net Income. Everything on the income statement flows from this simple equation.
The Income Statement Structure
Income statements flow from top to bottom, starting with revenue and subtracting various expenses to arrive at net income (the bottom line).
1. Revenue (Top Line)
Revenue, also called sales, is the total amount earned from selling products or services. This is the starting point for everything.
- Gross Revenue: Total sales before any deductions
- Net Revenue: Sales after returns, discounts, and allowances
Revenue growth is often the first thing investors look at. Consistent growth indicates a healthy, expanding business.
2. Cost of Goods Sold (COGS)
Direct costs to produce the products or services sold:
- Raw materials
- Direct labor
- Manufacturing costs
For service companies, this might be called "Cost of Revenue" and includes direct labor and materials for delivering services.
3. Gross Profit
Formula: Revenue - Cost of Goods Sold = Gross Profit
Gross profit shows how much money remains after direct production costs. This is the first measure of profitability.
4. Operating Expenses
Costs to run the business that are not directly tied to production:
- Research & Development (R&D): Costs to develop new products
- Sales, General & Administrative (SG&A): Marketing, salaries, rent, utilities
- Depreciation & Amortization: Spreading asset costs over their useful life
5. Operating Income (EBIT)
Formula: Gross Profit - Operating Expenses = Operating Income
Operating income, also called EBIT (Earnings Before Interest and Taxes), shows profit from core business operations. This is a key metric because it excludes financing decisions and tax situations.
6. Interest and Other Income/Expenses
- Interest Expense: Cost of borrowing money
- Interest Income: Earnings from cash investments
- Other Income/Expenses: Gains or losses from investments, currency, etc.
7. Pre-Tax Income
Formula: Operating Income - Interest Expense + Other Income = Pre-Tax Income
This is profit before paying taxes.
8. Net Income (Bottom Line)
Formula: Pre-Tax Income - Income Taxes = Net Income
Net income is the final profit after all expenses and taxes. This is what belongs to shareholders.
Real Example: Analyzing an Income Statement
Let us walk through a simplified example (all figures in millions):
- Revenue: $10,000
- Cost of Goods Sold: $6,000
- Gross Profit: $4,000
- R&D Expenses: $500
- SG&A Expenses: $1,500
- Operating Income: $2,000
- Interest Expense: $200
- Pre-Tax Income: $1,800
- Income Taxes (25%): $450
- Net Income: $1,350
Key Profit Margins
Margins show profitability as a percentage of revenue, making it easy to compare companies of different sizes.
Gross Margin
Formula: (Gross Profit / Revenue) x 100
Example: ($4,000 / $10,000) x 100 = 40%
Gross margin indicates pricing power and production efficiency. Higher margins mean the company keeps more of each dollar of sales.
Operating Margin
Formula: (Operating Income / Revenue) x 100
Example: ($2,000 / $10,000) x 100 = 20%
Operating margin shows how efficiently the company runs its core business. This is often the most important margin for comparing companies.
Net Profit Margin
Formula: (Net Income / Revenue) x 100
Example: ($1,350 / $10,000) x 100 = 13.5%
Net margin shows the final profitability after all expenses. Different industries have very different typical margins.
Earnings Per Share (EPS)
EPS is net income divided by the number of shares outstanding. It tells you how much profit each share represents.
Basic EPS
Formula: Net Income / Shares Outstanding
Example: If there are 500 million shares: $1,350M / 500M = $2.70 per share
Diluted EPS
Includes potential shares from stock options, convertible bonds, etc. Always more conservative than basic EPS.
EPS is used to calculate the P/E ratio: Stock Price / EPS. If the stock trades at $54, P/E = $54 / $2.70 = 20.
What to Look For
Positive Signs
- Consistent Revenue Growth: Growing sales indicate healthy demand
- Stable or Improving Margins: Shows pricing power and cost control
- Growing EPS: More profit per share over time
- Revenue Growing Faster Than Expenses: Operating leverage
Red Flags
- Declining Revenue: May indicate losing market share or industry decline
- Shrinking Margins: Could mean pricing pressure or rising costs
- One-Time Gains: Profits from selling assets are not sustainable
- Growing SG&A Faster Than Revenue: Inefficient operations
- Frequent "Adjusted" Earnings: Be skeptical of too many add-backs
Comparing Across Time and Companies
To get meaningful insights:
- Compare at least 5 years of income statements to spot trends
- Look at year-over-year growth rates for revenue and earnings
- Compare margins to industry peers
- Understand seasonal patterns (Q4 often stronger for retail)
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GAAP vs Non-GAAP Earnings
- GAAP: Generally Accepted Accounting Principles - the official, audited numbers
- Non-GAAP: Adjusted numbers excluding certain items (stock compensation, restructuring costs)
Companies often highlight non-GAAP earnings which look better. Always check both and understand what is being excluded.
Income Statement vs Cash Flow
The income statement uses accrual accounting - revenue is recorded when earned, not when cash is received. This can differ significantly from actual cash:
- A company can show profits but have no cash (customers have not paid)
- Depreciation reduces income but is not a cash expense
- Always compare income statement to cash flow statement for the full picture
Summary
The income statement shows a company's profitability over time, flowing from revenue through various expenses to net income. Key metrics include gross margin, operating margin, and net profit margin, which show profitability as percentages. Earnings per share (EPS) divides profits by shares outstanding. Look for consistent revenue growth, stable or improving margins, and be wary of declining sales, shrinking margins, or frequent one-time items. Always compare across multiple years and against industry peers for meaningful analysis.
Learn more: cash flow statement guide, fundamental analysis basics, and return on equity explained.