Understanding the income statement

As one of the three major financial statements, the income statement is like a funnel. It starts with the total revenue and then computes the net profits or net losses.

How to interpret this funnel?

An income statement is also known as a profit and loss statement. It tells investors how much a company earned or lost over the period.

An income statement can be divided into revenue, expenses, and profits or losses. An equation can represent their relationship. That is, revenue minus expenses equals net profits or net losses.

To better understand the items in the income statement, we can think of them as a funnel.

At the top is the net revenue, which is the sales of products or services after the deductions for returns and allowances.

Moving down is the cost of revenue. The number tells investors how much the company spent to produce the goods or services it sold during the accounting period. It usually includes the cost of labor, materials, and manufacturing overhead.

Subtracting the cost of revenue from the net revenue, we arrive at the gross profit. It is considered "gross" because it only includes variable costs and does not have fixed costs.

The next step is the operating expenses, which refer to the expenses that support a company's operation. Operating expenses usually include sales and marketing expenses, general and administrative expenses, and research and development expenses.

In addition, depreciation expense also needs to be deducted from gross profit. Depreciation refers to the wear and tear of a company's plant and equipment. After subtracting all operating expenses from the gross profit, we arrive at the operating profit.

Operating profit is the income derived from a company's core business operations. The company also has profits unrelated to its core business operations, called other income and expense. The item includes interest income, interest expense, and other gains and losses.

Interest income is the money generated from investments such as interest-bearing savings accounts or money market funds. On the other hand, interest expense is the cost incurred by borrowing money. After adding other income and subtracting other expenses, we get profit before income tax.

Now we are moving to the income tax. By deducting income tax, we finally reach the bottom: net profit or net loss. They tell you how much the company earned or lost during the accounting period.

In this way, a simple income statement is ready. 

For investors, analyzing the income statement is not just about the profits made. The growth changes are more vital.

For example, if a company's revenue increases significantly, it usually indicates that the company is growing rapidly. However, if operating expenses are growing faster than revenue, there may be a problem with the company's management.

As for net profit, it will be good if the company makes a large profit. However, a high net profit does not necessarily mean strong profitability. Profit margin also matters.

In the following video, we will focus on profit margin.