How to Create the Perfect Income Statement (2024)

Financial statements are tools for communicating financial information about a company topeople outside the business. A company’s three primary financial statements are thebalance sheet, the income statement and the statement of cash flows. Of these three, theincome statement is often considered to be the most important tool for communicating andmeasuring the success of the business.

What is an Income Statement?

An income statement reports a company’s revenue, expenses and profit or loss during aspecific accounting period. Income statements are also known as statements of earnings,statements of income, net income statements, profit and lossstatements or simply “P&Ls,” among other names.

Key Takeaways

• An income statement includes a company’s revenue, expenses, gains, losses andprofit for a specific accounting period.
• A company’s income statement is often considered the most important tool forcommunicating financial information to people outside the business.
• Income statements are used by managers, investors, lenders, and analysts to assess acompany’s profitability, growth and efficiency. They are also used to comparedifferent companies.
• Income statements can be produced in several formats, each providing a different levelof detail about the company’s operations.

Income statement vs. balance sheet

The company’s three main financial statements—the income statement, balance sheetandcash flow statement—each serve a different purpose, although they are interrelated.

A balance sheet provides a snapshot of the value of a company’sassets, liabilities and equity at a specific point in time, typically the last day of anaccounting period. Managers, investors and lenders often analyze balance sheets whenevaluating how much a business is worth.

In contrast, an income statement provides a dynamic view of the businessover a period of time—typically a month, quarter or year. It shows the revenue andprofitgenerated from operations as well as other gains and losses. Investors and otherstakeholders examine income statements to see how profitably leaders run a business.

The headings on these financial statements reflect the fact that a balance sheet is asnapshot taken at the end of a period, while an income statement reflects activities overthe entire period. For example, a quarterly balance sheet might show assets and liabilities“as of Dec. 31,” while the corresponding income statement shows profit“for the three monthsending Dec. 31.”

In both income statements and balance sheets, line items are often grouped into naturalcategories to help make the statements easier to read and help stakeholders find specificitems of interest. Balance sheets list current assets, long-term assets, total assets,current liabilities, long term liabilities, total liabilities and accumulated retainedearnings (or shareholder’s equity). Income statements show revenue, gains, expenses,losses and net income.

Income Statement Explained

Income statements present a great deal of information about a company’s activitiesduring a specific period. It may be tempting to focus on “the bottomline”—the amount of netincome—but there’s useful information throughout the entire income statement,from topto bottom.

By categorizing this data, the income statement can provide deeper insights into thecompany’s earnings. For example, separating operating expenses fromone-time charges, such as a loss due to theft or natural disaster, can provide a betterindication of the company’s likely future expense levels and profitability.

Why is an income statement important for your business?

Income statements are essential tools for communicating financial information to peopleoutside the business. A company can present its income statement as evidence of itsfinancial performance in order to obtain loans and investments, for example.

For the company’s managers, the income statement highlights the results of thecompany’s operating activities, including the critical relationship between revenue,expenses and profitability. This can help identify potential problems and areas that needimprovement.

How are income statements used?

Income statements are used by a variety of people outside and inside the company.

Investors are among the biggest users of income statements. They examine a company’shistorical performance, as reported on income statements, to determine its investment valueand creditworthiness and to help predict its future success. While past results don’tguarantee future success, they are the most common way of gauging the economic value of abusiness and the likelihood of repayment of debt.

Other users include tax authorities such as the IRS, which review income statements toevaluate a company’s tax liability. Customers may use a company’s incomestatements to assess its long-term viability and stability. Unions examine the statementsduring salary negotiations.

Income statements are also used in various ways within the company. The income statementprovides the foundation for many managerial accountingtools. Financial modeling, forecasting and analysis of key performance indicatorsuse income statement data to aid in decision making.

Single- vs multi-step income statements

Income statements can be reported in several different formats, with varying levels ofdetail. A simple, summarized financial statement helps readers quickly get an overview ofthe company’s results; a statement with more detail enables readers to find specificinformation that is important to them.

Regardless of how information is presented, the same underlying data and accounting methodsare used to create the statement. Two common formats are the single-step income statementand the multiple-step income statement.

What is a single-step income statement?

This format has one section for revenue and another for expenses. Each section maycontain multiple line items. Total revenue and expenses are listed at the end of therespective sections.

Net income, calculated as total revenue minus total expenses, is reported at the end of thestatement. “Single step” refers to the fact that only a single subtraction isneeded tocalculate net income.

What is a multiple-step income statement?

Multiple-step income statements are organized into separate sections for operating andnon-operating activities. Each section lists revenue and related expenses. The operatingactivities section lists revenues and expenses that are directly related to core businessactivities. The non-operating activities section lists other income and expenses, such asinterest payments on loans and realized gains or losses on investments.

A multi-step income statement also provides intermediary subtotals within each section. Forexample, the operating activities section typically includes subtotals, such as cost ofgoods sold (COGS) and gross profit. The multi-stepincome statement gets its name because multiple steps are needed to calculate net income.First, the subtotals are calculated from individual line items, then net income iscalculated from the subtotals.

Another common format is the condensed income statement, which includes onlysummary totals of each expense category. Supplementary detail is provided on supportingschedules.

What is a common-size income statement?

To help compare financial statements from different businesses, accountants may “commonsize”them. For an income statement, this means adding a column that expresses every line on thefinancial statement as a percentage of total revenue.

What’s Included in an income statement?

The items on a multi-step income statement are divided into sections that separate operatingrevenue and expenses from the results of non-operating activities, taxes and extraordinaryitems. Accountants use some judgement when organizing these items, using breakdowns thatmost naturally reflects how the business works. Therefore, an income statement from amanufacturer may look very different from one issued by a professional services company.

However, for any income statement, there is a specific definition for each listed item. Hereare some of the common elements included in multi-step income statements, listed in theorder they typically appear.

• Revenue: Sales of goods and/or services. The income statement may list gross salestogether with reductions for discounts, returns and allowances. These amounts arededucted from gross sales to provide an intermediate total called net sales revenue. Revenue from different productlines may be broken out as separate line items.
• Expenses: An umbrella term for costs incurred during the period. Often, expenses are groupedinto natural classifications, such as cost of goods sold (COGS) and selling, general andadministrative expenses (SG&A).
• COGS: A subset of operating expenses, COGS represents the direct costsof making or acquiring the products that generated revenue during the period. A servicesorganization may simply call this “cost of sales,” since it doesn’tsell “goods.”
• SG&A: Includes all non-production operating expenses, including the costs topromote, sell and deliver products. includes items like rent,salaries, commissions, advertising and marketing expenses, and shipping costs.
• Gross profit : An intermediary subtotal, calculated as net sales revenue minus COGS, gross profit is a keymetric used to assess the profitability and efficiency of a company’s corebusiness.
• Operating income : This is an intermediary subtotal calculated by subtracting alloperating expenses from net sales revenue. It can also be expressed as gross profitreduced by operating expenses outside of COGS, such as direct and indirect selling,marketing, general and administrative expenses. Operating income isalso referred to as earnings before interest and taxes (EBIT).
• Income before taxes: This is another intermediary subtotal, which is farther down theincome statement and therefore more comprehensive than the earlier subtotals. Income before taxesis total revenue minus total expenses, excluding taxes. Also known as earnings beforetaxes (EBT), this metric is useful for comparing companies because it peels away acompany’s tax expenses.
• Net income: This is the final calculation at the bottom of the income statement, andit’s often called “the bottom line” for that reason. It is the totalamount of allsales reduced by all expenses, including taxes. The formula for net income is:

Net Income = (revenue + gains) - (expenses + losses)

• Earnings per share: A metric used by public companies, earnings per share (EPS) iscalculated as net income divided by the number of shares outstanding. EPS is used as anindicator of business performance in prospectuses, proxy materials and annual reports.
• Depreciation: This is a noncash expense that reflects a fixed asset’s loss invalue over time. Depreciation expenses maybe listed in different parts of the income statement, depending on the assets that theyapply to. For example, depreciation of manufacturing equipment is typically a directcost that’s included in COGS, while depreciation of computers used byadministrative staff is included in other operating expenses. Amortization is ananalogous method applied to intangible assets, such as patents.
• EBITDA: Earnings before interest, taxes, depreciation and amortization (EBITDA) is a commonly usedmetric. It’s calculated by working upwards from the bottom of the incomestatement, adding back expenses that were deducted to arrive at operating income (EBIT)and net income. Adding back the noncash expenses of depreciation and amortization mayprovide insight into a company’s cash flows and can be helpful when comparingdifferent companies.

Video: Income Statement Explained

Revenues and Gains on the Income Statement

Revenue refers to money generated from operating activities. Depending onthe nature of the company’s business and the type of income statement used, there maybe several lines listing different sources of revenue, such as revenue from primary andsecondary activities, or revenue by business unit or geography.

Gains are net proceeds generated by peripheral activities. They are listedin a separate section lower down on the income statement because they are not part of theeveryday activities of a business. Common examples of gains include profits from disposal ofassets, selling investments and proceeds from lawsuits.

Expenses and Losses on the Income Statement

Expenses are costs related to running the business. Expenses are typicallybroken down into operating expenses and nonoperating expenses, and may be further subdividedinto categories. Within operating expenses, categories include COGS and SG&A.

Losses are reductions in net assets caused by incidental transactions. Theyare typically reported in a separate section of the income statement. Common examples oflosses include write-offs of obsolete assets, payments due to lawsuits and losses oninvestments.

What are the limitations of an income statement?

Though the income statement presents a considerable amount of useful information, it haslimitations. For example, unlike a statement of cash flows, an income statement does notdistinguish between cash and noncash activities. This can distort analysis of acompany’s viability: Insufficient cash flow is a common reason that apparentlyprofitable companies go out of business.

In addition, income statements reflect only business activities that can be reliablyquantified. For example, income statements don’t reflect missed business opportunitiesor positive or negative societal impacts.

The accounting method that a company uses also affects the income statement. Revenue andexpenses may differ depending on whether the company uses cash-basis accounting versusaccrual basis. The income statement is also affected by whether a company uses anaccelerated method of calculating depreciation versus a straight-line method. Thesedifferences can make it difficult to compare the income statements of differentcompanies—oreven the statements produced by the same company in different periods.

9 Steps to Prepare an Income Statement

When preparing an income statement, first determine the period that the statement will cover,such as a month, quarter or year. Often, income statements include both the current periodand a comparison with the corresponding period in the prior year.

Most modern accounting softwaresuites can generate standard financial statements, including income statements.However, it’s useful to understand the steps involved:

1. Review the trial balance after it’s been properly closed and adjusted for theperiod.
2. Identify and compile the revenue accounts for inclusion in the revenue section of theincome statement. These include sales accounts as well as any estimates for allowances,like bad debt or returns.
3. Find the expenses that roll into COGS, such as raw materials, direct labor andfreight-in. COGS is the first expense section listed on the income statement, readingtop to bottom.
4. Calculate gross profit by subtracting COGS from net sales revenue. You can also calculate gross margin bydividing gross profit by net sales revenue.
5. Aggregate the rest of the operating expenses, such as selling, marketing,administrative, travel, rent and other items, for inclusion in the operating expensessection of the income statement.
6. Calculate operating income as gross profit minus the operating expenses identified instep 5.
7. Insert any gains/losses or ancillary income and adjust income from operationsaccordingly to yield net income before taxes (EBT).
8. Calculate taxes based on the EBT amount.
9. Reduce EBT by the tax expense to get the net income for the period.

Income Statement Example

Sometimes a picture is worth a thousand words, as the following income statement examplesillustrate. They show a single fictional company’s results presented three differentways: as a condensed income statement, a single-step income statement and a multi-stepincome statement.

KMR Bakery Inc. is an incorporated bakery that sells artisan cupcakes and specialty coffee.KMR rents its store, has a revolving credit line for buying ingredients and supplies, andemploys several part-time workers. Occasionally, KMR rents out its facility for birthdayparties. During the year, KMR replaced its cappuccino machine, selling the old one, whichwas fully depreciated, for a gain. For quality purposes, no finished goodsinventory—bakedcupcakes or brewed coffee—is held overnight.

Condensed income statement example:

Single-step income statement example:

Multi-step income statement example:

Income Statement Analysis

The data on an income statement is analyzed by both internal and external users. Largeorganizations may have an entire department dedicated to financial planning and analysisthat constantly scrutinizes the results of operations.

External users may be focused on a particular section of the income statement, such asinterest expense, or they may use the data on the income statement to compute financialratios for comparison with those of other companies.

In general, most income statement analysis can be thought of in three ways:

1. Horizontal analysis is the comparison of the same item over differentperiods, with an eye toward identifying trends or changes compared to a benchmark. Someexamples include:
   1. Overall period-to-period comparisons, such as comparing Q1 2019 to Q1 2020
   2. Seasonal revenue comparisons
2. Ratio analysis uses industry-standard formulas to look at therelationships between different aspects of the business. These ratios are also used incomparisons with other companies and industry benchmarks, and when comparing thecompany’s performance in different periods. Some examples include:
   1. Price to earnings ratio (for public companies)
   2. Revenue mix by product line
   3. Gross margin (gross profit divided by revenue)
   4. Selling, general & administrative costs as a percentage of revenue, trendingover time
   5. Contribution margin and breakeven analysis
3. Line item analysis takes a deep dive into a particular item on theincome statement to examine its components in more detail. This is typically performedto ensure items aren’t missing—especially activity that occurs near eitherside ofa cutoff period. It’s also used to examine items that are based on estimates. Anyline items can be analyzed in this way.

Income Statement Template

You can use this free downloadable income statement template to create your own incomestatements. Download the template.

How to Prepare an Income Statement in a Financial Model

Income statements are also used in financial modelling. Financial modelling can helpcompanies forecast future performance or analyze the impact of anticipated changes to thebusiness, such as making an acquisition or discontinuing a product line.

The income statement is used in financial modeling as a template and a checklist, to frameassumptions and reflect their impact. It’s useful for these purposes because ithighlights the relationships between revenue and expenses, gains, losses, and the relatedtax effects and changes to EPS.

Financial modelling often uses common-size income statements. Basic financial models areoften prepared using spreadsheet templates, but more sophisticated modelling is done usingfinancial planningproducts, especially those that integrate with a company’s accounting systems.

What are Common Drivers for Each Income Statement Item?

Financial modelling, forecasting and budgeting processes are a mixture of art and science.Most forecasting methods start by gathering historical data and identifying key businessdrivers. This information is used to create financial estimates that are incorporated intoan income statement. Some common drivers of income statement items are summarized below.

Bottom line (no pun intended) the income statement is a critical toolfor communicating a company’s performance to people outside and within the company.The data in income statements can be analyzed for many different purposes, includingidentifying trends, developing forecasts and comparing the company with competitors.

Companies with the most automated andintegratedaccounting systems, which handle data at the deepest levels, generate the mostaccurate financial statements and can more easily perform robust income statement analysisand prospective financial modelling. Additionally, these systems are invaluable forauditability and compliance.