Reading an Income Statement

How a company's income statement moves from sales at the top to profit at the bottom, and what each line tells you.

Every company that reports its finances publishes three main statements. The first most people look at is the income statement, also called the profit and loss account. It shows how much money a company earned and spent over a period, usually a quarter or a year, and whether it made a profit.

From top line to bottom line

An income statement works like a staircase, starting with sales and subtracting costs step by step.

Revenue: the total money earned from selling goods or services. Often called the top line.
Cost of goods sold: the direct cost of making what was sold, such as materials and factory labour.
Gross profit: revenue minus cost of goods sold.
Operating expenses: costs of running the business, such as salaries for office staff, rent, marketing and research.
Operating profit: gross profit minus operating expenses. It shows how profitable the core business is.
Interest and taxes: interest on debt and taxes on profit are then subtracted.
Net income: the final profit, often called the bottom line.

Margins

Comparing profit to revenue gives profit margins. A company with 100 million dollars of revenue and 10 million dollars of net income has a net margin of 10 percent. Margins vary greatly by industry. Supermarkets often have thin net margins of a few percent, while software companies can have much higher margins.

A small bakery's year

A bakery sells 500,000 dollars of bread and cakes. Flour, butter and bakers' wages directly tied to baking cost 250,000 dollars, leaving gross profit of 250,000 dollars. Rent, the shop manager's salary and advertising cost 180,000 dollars, leaving operating profit of 70,000 dollars. After 10,000 dollars of interest on a loan and 15,000 dollars of tax, net income is 45,000 dollars, a net margin of 9 percent.

What it does not show

The income statement follows accrual accounting: it records sales when they are made and costs when they are incurred, not when cash actually moves. So a company can report a profit while running short of cash, for instance if customers have not yet paid. That is why investors also look at the cash flow statement.

Judging a company only by revenue growth

Fast-growing revenue sounds impressive, but if costs grow even faster, the company may be losing more money each year. Revenue tells you how much a company sells, not whether selling it is profitable.

Key takeaways

The income statement shows revenue, costs and profit over a period.
It moves from revenue through gross profit and operating profit to net income.
Profit margins compare profit with revenue and vary greatly by industry.
Accrual accounting means profit and cash are not the same thing.