An income statement is one of the main financial statements used by accountants, analysts and business owners to show the profitability of a company during a specific period of time.
The income statement is usually prepared after the adjusted trial balance during the accounting cycle. It is also the first financial statement that needs to be prepared since the net income figure calculated is then transferred to the statement of retained earnings in the balance sheet.
The income statement might also be referred to as the profit and loss (P&L statement), the statement of earnings, the statement of operations or the statement of income.
One thing you need to have clear when thinking about the income statement is that it shows the revenues, expenses and profit (or losses) of a company. It does not show cash receipts that you receive or cash disbursements that you pay out.
The net profit of a company is useful for the investors and creditors of a company on determining how efficiently a company is operating.
A company that does not operate profitability would be a risk to investors, bankers, lenders or creditors who may not want to give the company capital if it is not able to use it to generate profits.
A company that has a history of generating profit, on the other hand, is a much more attractive prospect to lenders or investors.
Income Statement Template
Throughout this series on financial statements, you can download the Excel template below for free to see how Bob’s Donut Shoppe uses the income statement (and others) to evaluate the performance of his business.
Purpose of the Income Statement
There could be several reasons for creating a financial statement and it ultimately depends on the end-user. For instance, an annual statement would be very useful for an investor or a creditor to judge the annual performance of a company. However, for internal management, a monthly or a quarterly income statement would be better suited as it would help them determine whether the company operations are on the right track or not.
Internal management can also request an annual income statement to be segmented as per business activity. For instance, conglomerate businesses with multiple revenue segments would want to know how each if its businesses are performing. This is because overall a company can still be in a profit with one or two of its business segments severely underperforming. The segmented profit and loss account would help identify underperforming businesses and then a decision could be made whether to revive the segment through additional capital investment or divesting the business altogether.
Users of the Income Statement
The income statement essentially has two key groups of people that utilize the information for decision making:
- Internal users
- External users
These include the internal management, board of directors and the employees. The internal management and board of directors can use the information related to the profitability of a company to make key decisions such as expansion, the closing of a business segment, cost-cutting, production scheduling, etc.
An employee can also use the income statement of a company for his or her own analysis of how the company is performing against its competitors. The employee can then make decisions such as switching to another employer, asking for a raise, demanding a bonus, etc. If the company is doing well, the employee can plan his career path in it accordingly.
These mainly include investors, creditors, and competitors. This group of people has no other source of a company’s financial performance besides these published reports. A current shareholder might want to how the company is performing and the return on his investment for the period. A prospective investor might want to study a company’s financials to decide whether to buy its shares and become a shareholder.
Creditors will closely study the company’s income statement to determine whether the company can pay-off its liabilities and obligations within the scheduled repayment dates. A company with strong profitability will have a better interest coverage ratio, which means that it is safe to assume that the creditor would get his money back with interest.
Competitor’s might also draw on studying the financial performance of a company to gauge how the relative position and market standing. They might also be seeking information about whether it is profitable to enter a new business, develop a new market segment, introduce a new distribution strategy, etc.
Income Statement Format and Preparation
The income statement can be prepared in two ways:
- Single-step income statement
- Multi-step income statement
A single-step income statement lists down all expenses under a single category. It does not make a distinction between non-operating expenses, operating expenses, or cost of goods. All the revenues and expenses are listed together. Many smaller companies might use this method of presenting their income statement as is simpler and easier to understand. A single-step income statement will hardly list more than a few major categories of expenses.
A multi-step income statement will make a distinction between different categories of income and expenses by segregating them into operating and non-operating activities. Operating activities include revenues and expenses that are directly related to a company’s operations. Non-operating revenues and expenses do not directly relate to a company’s operations. Therefore, a multi-step income statement is a more in-depth way of presenting an income statement and makes it easier for the user to understand the core operations of a company.
A multi-step income statement would follow multiple steps to arrive at the net income figure. These steps are listed below:
- Subtract the cost of goods sold from revenues to calculate gross profit.
- Subtract operating expenses from gross profit to calculate operating income.
- Add/subtract non-operating income and expenses to calculate net income.
Income Statement Example
Below is a an example of a single-step income statement for Bob’s Donut Shoppe, Inc. A company we have explored during the accounting cycle series.
You can see that the revenues and expenses have been listed under a single heading and it is very easy to read and understand.
The downside to this is that it does not provide the level of detail required by an external user. This is why public companies and even private companies to some extent are required to show a multi-step income statement. This is especially a key requirement when these companies go to ask for loan approval from a bank or other financial institution.
With the multi-step example below, you can see that it provides more detail in the operations of the business and allows users of the income statement to see more clearly what the gross profit, operating income, and net income for the company are.
Differences between Single and Multi-Step Income Statements
The key differences that are important to note are:
- A single-step income statement uses only one step to calculate the net income, i.e. subtract expenses from revenues. Whereas, a multi-step statement uses numerous steps to arrive at the final net income figure
- A single-step income statement shows only net income, whereas a multi-step income statement shows gross profit in addition to net income.
- A single-step income statement is generally used in the services industry. A multi-step statement is used for manufacturing businesses.
- Single-step statements are known to be concise and lacking details. A multi-step statement is more comprehensive.
- A single-step income statement treats the cost of goods sold as expenses. This is not the case in a multi-step income statement.