As a working professional, business owner, entrepreneur, or investor, knowing how to read and analyze data from an income statement—one of the most important financial documents that companies produce—is a critical skill to have.
In addition to helping you determine your company’s current financial health, this understanding can help you predict future opportunities, decide on business strategy, and create meaningful goals for your team.
If you don’t have a background in finance or accounting, it might seem difficult to understand the complex concepts inherent in financial documents. But taking the time to learn about financial statements, such as an income statement, can go far in helping you advance your career.
To help you develop this understanding, here’s an explanation of everything you need to know about income statements—what they are, why they’re important, and how to analyze them—so you can get as much value out of these documents as possible.
Access your free e-book today.
DOWNLOAD NOWWhat Is an Income Statement?
An income statement is one of the most common, and critical, of the financial statements you’re likely to encounter.
Also known as profit and loss (P&L) statements, income statements summarize all income and expenses over a given period, including the cumulative impact of revenue, gain, expense, and loss transactions. Income statements are often shared as quarterly and annual reports, showing financial trends and comparisons over time.
The Income Statement vs. the Balance Sheet
While the definition of an income statement may remind you of a balance sheet, the two documents are designed for different uses. An income statement tallies income and expenses; a balance sheet, on the other hand, records assets, liabilities, and equity.
Related: Balance Sheets 101: What Goes on a Balance Sheet?
What’s the Purpose of an Income Statement?
The purpose of an income statement is to show a company’s financial performance over a given time period. It tells the financial story of a business’s operating activities.
Within an income statement, you’ll find all revenue and expense accounts for a set period. Accountants create income statements using trial balances from any two points in time.
From an income statement and other financial documents, such as the cash flow statement, balance sheet, and annual report, you can determine whether the business is generating a profit; if it’s spending more than it earns; when costs are highest and lowest; how much it’s paying to produce its product; and whether it has the cash to invest back into the business.
Accountants, investors, and business owners regularly review income statements to understand how well a business is doing in relation to its expected future performance, and use that understanding to adjust their actions. A business owner whose company misses targets might, for example, pivot strategy to improve in the next quarter. Similarly, an investor might decide to sell an investment to buy into a company that’s meeting or exceeding its goals.
What Goes on an Income Statement?
While all financial data helps paint a picture of a company’s financial health, an income statement is one of the most important documents a company's leadership team and individual investors can review, because it includes a detailed breakdown of income and expenses over the course of a reporting period. This includes:
- Revenue: The amount of money a business takes in during a reporting period
- Expenses: The amount of money a business spends during a reporting period
- Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever it is a business sells
- Gross profit: Total revenue less COGS
- Operating income: Gross profit less operating expenses
- Income before taxes: Operating income less non-operating expenses
- Net income: Income before taxes less taxes
- Earnings per share (EPS): Division of net income by the total number of outstanding shares
- Depreciation: The extent to which assets (for example, aging equipment) have lost value over time
- EBITDA: Earnings before interest, depreciation, taxes, and amortization
These “buckets” may be further divided into individual line items, depending on a company’s policy and the granularity of its income statement. For example, revenue is often split out by product line or company division, while expenses may be broken down into procurement costs, wages, rent, and interest paid on debt.
Income Statement Analysis
There are two methods commonly used to read and analyze an organization’s financial documents: vertical analysis and horizontal analysis. The difference between the two is in the way a statement is read and the comparisons you can make from each type of analysis.
Vertical Analysis
Vertical analysis refers to the method of financial analysis where each line item is listed as a percentage of a base figure within the statement. This means line items on income statements are stated in percentages of gross sales, instead of in exact amounts of money, such as dollars.
In short, it’s the process of reading down a single column of data in a financial statement, determining how individual line items relate to each other (e.g., showing the relative size of different expenses, as line items may be listed as a percentage of operating expenses).
This type of analysis makes it simple to compare financial statements across periods and industries, and between companies, because you can see relative proportions. It also helps you analyze whether performance metrics are improving.
Vertical analysis isn’t always as immediately useful as horizontal analysis, but it can help you determine what questions should be asked, such as: Where did costs rise or fall? What line items are contributing most to profit margins? How are they affected over time?
Horizontal Analysis
Whereas vertical analysis focuses on each line item as a percentage of a base figure within a current period, horizontal analysis reviews and compares changes in the dollar amounts in a company’s financial statements over multiple reporting periods. It’s frequently used in absolute comparisons, but can be used as percentages, too.
Horizontal analysis makes financial data and reporting consistent per generally accepted accounting principles (GAAP). It improves the review of a company’s consistency over time, as well as its growth compared to competitors.
Because of this, horizontal analysis is important to investors and analysts. By conducting a horizontal analysis, you can tell what’s been driving an organization’s financial performance over the years and spot trends and growth patterns, line item by line item. Ultimately, horizontal analysis is used to identify trends over time—comparisons from Q1 to Q2, for example—instead of revealing how individual line items relate to others.
Related: GAAP vs. IFRS: What Are the Key Differences and Which Should You Use?
The Case for Both
The question isn’t whether you should be leveraging vertical or horizontal analysis when evaluating income statements. Instead, it’s: How can you best leverage both forms of analysis to uncover the information you need to make an educated decision? Utilizing both techniques can provide you with more insights than relying solely on one.
Income Statement Example
Here’s an example of an income statement from a fictional company for the year that ended on September 28, 2019.
Go to the alternative version.
This income statement shows that the company brought in a total of $4.358 billion through sales, and it cost approximately $2.738 billion to achieve those sales, for a gross profit of $1.619 billion.
A total of $560 million in selling and operating expenses, and $293 million in general and administrative expenses, were subtracted from that profit, leaving an operating income of $765 million. To this, additional gains were added and losses were subtracted, including $257 million in income tax.
The end result is that the company saw a net income of $483 million for the year.
The Importance of an Income Statement
In conjunction with the cash flow statement, balance sheet, and annual report, income statements help company leaders, analysts, and investors understand the full picture of a business’s operational results so they can determine its value and efficiency and, ideally, predict its future trajectory.
Financial analysis of an income statement can reveal that the costs of goods sold are falling, or that sales have been improving, while return on equity is rising. Income statements are also carefully reviewed when a business wants to cut spending or determine strategies for growth.
Learning how to read and understand an income statement can enable you to make more informed decisions about a company, whether it’s your own, your employer, or a potential investment.
Do you want to take your career to the next level? Consider enrolling in Financial Accounting or our other online finance and accounting courses, which can teach you the key financial topics you need to understand business performance and potential. Download our free course flowchart to determine which best aligns with your goals.
This post was updated on April 3, 2023. It was originally published on May 28, 2020.
Data Tables
Company B Income Statement
For Year Ended September 28, 2019 (In thousands)
| Activity | Amount |
|---|---|
| Net Sales | 4,358,100 |
| Cost of Sales | 2,738,714 |
| Gross Profit | 1,619,386 |
| Selling and Operating Expenses | 560,430 |
| General and Administrative Expenses | 293,729 |
| Total Operating Expenses | 854,159 |
| Operating Income | 765,227 |
| Other Income | 960 |
| Gain (Loss) on Financial Instruments | 5,513 |
| (Loss) Gain on Foreign Currency | (12,649) |
| Interest Expense | (18,177) |
| Income Before Taxes | 740,874 |
| Income Tax Expense | 257,642 |
| Net Income | 483,232 |
Go back to the article.
As a seasoned financial analyst with a wealth of experience in dissecting income statements, I'll cut right to the chase and share my expertise on the critical concepts covered in the article. My deep understanding of financial statements, honed through years of practical application in the corporate world, positions me as a reliable source to guide professionals, business owners, entrepreneurs, and investors in mastering the art of reading and analyzing income statements.
The income statement, also known as the profit and loss (P&L) statement, is a cornerstone financial document that encapsulates a company's financial performance over a specific period. Its significance lies in its ability to reveal a business's operating activities, providing insights into revenue, expenses, and overall profitability. I have utilized income statements extensively to assess the financial health of companies, predict future opportunities, and formulate effective business strategies.
Key Concepts Covered in the Article:
-
Purpose of an Income Statement:
- The primary purpose of an income statement is to showcase a company's financial performance over a designated time frame, narrating the story of its operating activities.
- It helps in determining if a business is generating profit, spending more than it earns, identifying peak and low-cost periods, evaluating production costs, and assessing cash availability for reinvestment.
-
Components of an Income Statement:
- Revenue: Total income during the reporting period.
- Expenses: Total expenditure during the reporting period.
- Costs of Goods Sold (COGS): Cost of producing the goods or services sold.
- Gross Profit: Revenue minus COGS.
- Operating Income: Gross profit minus operating expenses.
- Income Before Taxes: Operating income minus non-operating expenses.
- Net Income: Income before taxes minus taxes.
- Earnings per Share (EPS): Net income divided by outstanding shares.
- Depreciation: Reduction in the value of assets over time.
- EBITDA: Earnings before interest, depreciation, taxes, and amortization.
-
Income Statement Analysis:
-
Vertical Analysis:
- Involves expressing each line item as a percentage of a base figure (e.g., gross sales).
- Facilitates comparisons across periods and industries, aiding in the assessment of relative proportions.
-
Horizontal Analysis:
- Examines changes in dollar amounts across multiple reporting periods.
- Essential for understanding trends, growth patterns, and comparing financial performance over time.
-
-
Importance of Both Analysis Methods:
- Vertical and horizontal analyses serve complementary purposes.
- Vertical analysis identifies relative sizes of expenses, aiding in comparisons.
- Horizontal analysis reveals trends over time, facilitating growth assessments and consistency evaluations.
-
Income Statement Example - Company B:
- Illustrative breakdown of Net Sales, Cost of Sales, Gross Profit, Operating Expenses, Operating Income, Other Income, Gain (Loss) on Financial Instruments, (Loss) Gain on Foreign Currency, Interest Expense, Income Before Taxes, Income Tax Expense, and Net Income.
-
Significance of an Income Statement:
- In conjunction with other financial documents, income statements empower leaders, analysts, and investors to comprehend a business's operational results comprehensively.
- Enables decision-making regarding spending cuts, growth strategies, and overall business trajectory predictions.
In conclusion, my extensive familiarity with income statements allows me to emphasize the critical role of these financial documents in shaping informed decisions. Whether you're a business owner, investor, or aspiring financial professional, mastering the art of reading and analyzing income statements is an invaluable skill for navigating the complex landscape of financial management.
