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Business

How to Read and Understand an Income Statement

Written by MasterClass

Last updated: Jun 17, 2020 • 3 min read

Whether you’ve just started your first small business or you’re a start-up expert, you’ll need to know how to create and read an income statement—a crucial part of a company’s financial reporting.

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What Is an Income Statement?

An income statement is a financial statement that details a company’s revenue, expenses, and losses over a specific time period in order to show the company’s net profit (or net loss). Also called a profit and loss statement (P&L), a net income statement, or a statement of earnings, your income statement shows the profitability of your business—whether you’re using it internally, or showing it to banks and investors to encourage them to invest.

An income statement is one of the three most important financial statements in business accounting, along with a balance sheet and a cash flow statement (also called a statement of cash flow).

What Information Does an Income Statement Contain?

An income statement should include the following line items:

  1. Total revenue: Revenue (also called sales revenue or operating income) is the income that your company received from its normal business operations.
  2. Cost of goods sold: The cost of goods sold (also called COGS or cost of sales) is the direct cost of the goods or services that your company sells—for instance, the price your company pays to make the product it sells, including the raw material and labor costs.
  3. Gross profit: Gross profit is your total revenue minus your COGS—in other words, it’s how much your company would have made if it incurred absolutely no other expenses. Gross profit isn’t necessary to list on an income statement, but it’s a great way to put your expenses in perspective.
  4. Itemized expenses: All income statements should have a detailed list of individual expenses—from rent; to selling, general, and administrative expenses (SG&A); to equipment and marketing expenses. Many companies will also include depreciation expenses in their total expenses, to show the cost of their fixed assets. Some companies separate their expenses into operating costs (internal day-to-day expenses that you have more control over) and non-operating expenses (like income taxes and interest expenses, which are external). Separating the expenses this way allows companies to calculate their operating profits.
  5. Net profit: Your company’s net profit (also called net sales or net earnings) is the gross profit minus expenses, and is the final line on your income statement. This is the numeric indicator of how your company profited or lost during a specific period of time, whether you’re compiling a monthly, quarterly, or annual income statement.
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How to Read an Income Statement

An income statement is a series of line items that should be read from top to bottom:

  1. The top lines: The items at the top of your income statement are the “rough draft” of your profitability, including your revenue, COGS, and gross profit. These numbers are what many people think of when determining a business’s profitability, but they don’t show the whole picture. These items are the least detailed information on your income sheet. They serve as the foundation for the accounting of your company profits.
  2. The middle: As you scan down the income statement, it should become more specific, detailing the expenses that many business owners don’t immediately think of when first starting a business—from marketing costs to research and development to depreciation.
  3. The bottom line: The bottom line of your income statement is where you’ll find the most specific and detailed piece of info: your net profit, or the amount your company made from sales after taking into account every expense. The bottom line is the most accurate representation of your company’s financial performance during a specific reporting period.

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