Definition of Income Statement
The income statement is used to find the financial performance of a company. An income statement shows the performance of a company for a period. The revenue and expenses are recorded in the Income Statement to calculate the profit and loss in a given period.
How to Create an Income Statement?
The Income Statement can be prepared by following the few simple steps mentioned below:
Step 1: Selection of The Reporting Period
Companies report financial performances both quarterly and yearly. When an accountant plans to prepare an Income statement, he should decide the period for which the Income Statement will be made. Public companies must make timely disclosures of financial statements to the public.
Step 2: Generate Closing Balances
Separate line items appearing in the Income statement will come from different accounts. The separate accounts are called ledgers. The closing balance of all the ledgers can be found in the trial balance. So the accountant will have to generate the closing balance of different ledgers and match the Trial Balance report.
Step 3: Calculation of Revenue
Revenue is the first line item in Income Statement. Whatever the company does, sales in a given period will come under revenue. Revenue is money that is generated from the actual operation of a business. For example, if a particular company is engaged in shoe production, then the company’s primary revenue will come from the sale of shoes.
Step 4: Calculation of Variable Cost
Variable cost is the cost that varies as per the production quantity. So if a particular product is produced more, the variable cost will also increase as per production rate. The accountant will have to determine the variable cost associated with a single quantity and then multiply it with the total production quantity. This will help the accountant to get the total variable cost. Variable cost needs to be deducted from revenue to get a contribution.
Step 5: Determination of Contribution
The remainder is called a contribution when the accountant deducts the total variable cost from total revenue. If you concentrate on the word “contribution,” it is trying to mean that this amount is trying to contribute to something. We all know that a company’s most important cost is fixed, as it needs to be paid even if the production is nil. So this amount contributes to the most important cost, which is fixed cost.
Step 6: Calculation of Fixed Cost
Fixed cost doesn’t change with the production quantity. So the accountant needs to collate all the fixed commitments that the firm has. The fixed cost usually contains the fixed production cost and fixed selling and administrative expenses. Fixed cost is deducted from contribution to get “Earnings before Interest and Taxes.” Operating profit is the profit generated from the firm’s core operation.
Step 7: Determination of Interest Paid by The Company
The company issues bonds to raise capital from the market. The interest charged by the bondholders is a non-operating expense. Therefore, it must be deducted from operating profit(earnings before interest and tax) to get “Earnings before tax.”
Step 8: Calculation of Tax and Generation of Net Income
The tax rate is charged on the Earnings before tax. The remainder is called the Net Income or profit of the company for the period.
Example of Income Statement
Company XYZ is preparing for the annual result. The external auditor that the company has hired is calculating the net profit for the company. The details are mentioned below
- Sales = $1,000,000
- Variable Cost = $200,000
- Fixed Cost = $300,000
- Interest Paid = $100,000
- Tax Rate = 20%
Solution:
The Net Profit of the company is 32,000
Components
Some of the components are as follows:
- Revenue: All the sales generated by a company in a particular period are recorded under revenue. These are operating incomes that the company generates through its core operation.
- Variable Cost: These are costs related to each item that is sold. When the production increases, the variable cost also increases. Variable cost is directly linked to the production of the individual item. It is the manufacturing cost.
- Fixed Cost: It doesn’t vary with the number of goods produced. These are mainly indirect overhead expenses, such as Factory rent, etc.
- Interest Cost: Whenever a company issues bonds to raise money, there are fixed interest charges that the company will have to pay. Higher the interest charge, the more levered the company is. Too much leverage may attract bankruptcy.
- Tax: Every company has a different tax structure. The tax is charged from Earnings Before tax, and we get Net Income after that.
Uses of Income Statement
It can be used for a variety of purposes.
- Revenue Tracking: An analyst will not know the firm’s revenue if the Income Statement is not published regularly. The first item of an Income statement is revenue. Proper documentation regarding actual sales needs to be maintained for validation of the revenue figure shown in the Income statement.
- Profitability Calculation: A firm may make a huge amount of sales, but its profitability can be low due to high expenses. Profitability increases when expenses are controlled. So it portrays an accurate picture of the expenses of a firm.
- Business Activity: A firm’s net income can also increase from selling old assets. These incomes are not part of operations. So it helps analysts to understand the exact income that is coming from operations.
Why Is Income Statement Important?
It is part of the Financial Statements being released by the company regularly. It helps analysts understand a particular company’s profitability, income, expense, etc.; all the information mentioned in the Income Statement is extremely important for stakeholders, analysts, tax authorities, and others. It is the doorway to the company’s operations.
Limitations
Some of the limitations are given below:
- It is prepared based on accrual accounting. Therefore, the sales reflected in the Income Statement may not be the actual sales as per the cash-flow statement. The cash flow statement reflects the sales for which the company has received cash. Any sales made on credit will not reflect in the cash-flow statement. So the sales reflected under the Income statement may be misleading.
- All the items reflected in the income statement are based on accounting rules, so management can manipulate them to show rosy pictures to the stakeholders.
Conclusion
An income statement is extremely important to gauge a company’s financial performance. All important line items are part of the Income statement. In addition, several important ratios can be calculated by studying a company’s income statement.
Recommended Articles
This is a guide to Income Statement. Here we also discuss the introduction and how to create an income statement, along with its uses and limitations. You may also have a look at the following articles to learn more –
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