Income Statements

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Income Statement

An income statement shows a business’ financial performance over a period of time. It shows the revenue, costs and profits of a firm. There are two main components of an income statement:

Trading account

This shows the total revenue a firm has made from sales, the cost of sales and the gross profit.
Cost of sales are any costs that are directly associated with making and selling the products.
- For example, for a firm like Aston Martin that manufactures and sells cars, the costs of sales would include the cost of the materials to make the cars and the cost of the labour that helped to make and sell the car. It does not include things like rent for the factory or advertising.
Gross profit = Revenue - Cost of Sales

Profit and loss account

This includes all expenses not directly involved in making and selling the product. It works out net profit.
Other expenses included are rent, advertising, depreciation and much more.
Operating Profit = Gross Profit – Expenses
Net Profit = Total Revenue - Total Costs. This is the amount left over after all costs (including interest payments) have been taken away.

Example

Revenue: £50,000
Cost of sales: £20,000
Gross profit: £30,000
Expenses (rent, advertising, wages): £15,000
Operating profit: £15,000
Interest and other costs: £5,000
Net profit: £10,000

Interpreting the Income Statement

Financial statements may be used by lots of stakeholders (shareholders, investors, suppliers and creditors). The income statement tells us about a business’ performance.

Profit

Profit is the most important thing to look at because it is what owners and investors aim to make. If a firm is making a loss then it can be a worrying sign.
Financial statements can help you to analyse why a firm might make a loss. If a firm is making a loss, look at gross profit, operating profit and net profit to see where a firm might be going wrong.

Costs

Comparing a firm’s costs to costs in previous years and the costs of competitors can help us to understand what is happening to a company’s cost base.

Margins

Profit margins are a very important measure of a whether a firm has the potential to be very profitable.
The gross profit margin shows the profit margin when only including the direct costs associated with making and selling the product. If a firm’s gross profit margin is negative or very low then it is a very worrying sign for the firm.
If the gross profit margin is positive but the net profit margin is negative, then it is important to try and analyse which expenses may be the largest and may be causing this difference.

Competitors

Comparing a firm’s current financial performance to competitors gives a good indication of whether the firm is doing well in its specific market.
A firm may seem to be very profitable with high profit margins but when compared to its competitors its profits and profit margins are much lower.
This gives us more information because it shows that the firm has room for improvement.

Year on year improvement

Comparing a firm’s income statement to previous years will show whether the firm’s performance is improving over time or getting worse.
- Growth – comparing revenue to previous years will show whether the firm is growing or not in terms of its sales revenue.
- Costs – will show how the costs the firm is facing are changing over time. In particular, if the firm suddenly goes from making a profit to making a loss, comparing it to previous years will show which costs have increased and are causing the drop in performance.