An income statement is one of the five financial statements that readers rely on. It is important for an organization to prepare an income statement that reflects the fair and true value of the business.
An income statement shows the company’s income and expenses over a specific period of time. It is not prepared on a specific date but is prepared for a specific period.
There are two forms of preparing an income statement- one is the single step and the other is the multi step. In a multi step income statement, there are four different measures of profitability: gross profit, operating profit, profit before tax, and profit after tax. An understanding of the income statement is important for investors who need to analyze the profitability and growth of the company.
Purpose of the statement
- The main purpose of an income statement is to provide the stakeholders, a summary of the performance of the company in a specific period. The activity and the quantum of activity that is performed by the company in this period are shown in the statement.
- An income statement helps in the comparison of the company under analysis with its peer companies and with the previous year’s performance. Majority analysts who track the stock of the company use income statement to understand the numbers. A comparison provides an insight into how well the company is functioning and how stable it is.
- A statement of income helps in forecasting in the company. When you take the past performance numbers of the company, it is possible to get revenue projections.
- The statement of income will show the classification of revenue and expenses across each department in the company. It will indicate to the management about the expenses that are growing at a higher rate and those that need to be cut down in the coming period.
- The statement helps in ratio analysis and valuation of the company. There are analysts who track the company to understand the ratios and their impact on stock value. Several income ratios can be calculated using the information on an income statement.
- Publicly listed companies are bound to report the financial statement at the end of the period and income statement forms an important part of the public listed company.
Preparation of an income statement
There are two main formats for the income statement and they are explained in an example below.
|Single-step format||Multi-step format|
|Net Sales||Net Sales|
|Production and Material||Cost of Sales|
|Administrative and Marketing||Gross Profit|
|Research and Development expenses||General, Selling and administrative expenses|
|Other income and expenses||Operating income|
|Pretax income||Other income and expenses|
|Net income after tax|
Both methods reflect the same result but in different ways. In the multi-step statement, the profitability measures will be revealed at four areas in the operations of the company- Gross, operating tax, pretax, and after-tax income. In contrast, in the single-step presentation, the gross income and operating income figures are not specifically stated but can be derived from the information provided.
An income statement is prepared with an accrual method of accounting which means that the revenue will be recognized when the goods are shipped or services provided.
Income statement example
Let us take a look at an income statement example for ABC company for the year ending 2018 and 2019.
Income Statement For Company ABC FY 2018 and 2019
|Cost of Sales||(375,000)||(350,000)|
|Other Income (Expense)||60,000||40,000|
|Net Profit Before Taxes (Pretax Income)||1,255,000||925,000|
Based on this example, we can deduce that ABC generated high income in the year 2018 as compared to 2019. It is interesting to note that the net sales and gross income declined in 2019 and this has led to an overall decline in net income. The general operating expenses have been maintained over the years and other expenses have slightly declined.
Each item in the income statement is of significant importance and shares great insights into the functioning of the company. It can be concluded that ABC is in a favorable position in 2019, even with a slight decline in sales and net income.
Whenever an investor understands the income statement, they can appreciate what makes the company different. What generates profits and how the company controls costs. It shows the stability, efficiency, and liquidity of the company. An investor may not make an investment decision by simply looking at the income statement but it will give an insight into the profitability of the company.