Updated July 29, 2023
Definition of Income Statement
All publicly-traded companies are required to release an income statement either quarterly or yearly. Three major items complete the structure of an income statement – revenue, expenses, and net profit. It shows the company’s performance over a particular period.
In other words, it is a company’s profit and loss account. Moreover, an income statement has two main sections – the operating and non-operating sections. The operating section deals with the day-to-day business activities of the company. In contrast, the non-operating section records all the revenues and expenses unrelated to the company’s regular business activities.
Purpose of Income Statement
The purpose of income statements is as follows:
Income Statement Purpose #1
Mainly, income statements are prepared for assessing a company’s financial performance over a specific period of time. The performance could be presented quarterly or yearly. Also, various stakeholders are interested in knowing how well the company is functioning, which are the business activities it has undertaken, its revenue and expense figures for the year, etc. For instance, the following income statement of a toy company shows us its performance during the year 2018.
Teddy’s Toy Shop, Inc. Income Statement For the Year Ended December 31, 2018
|Merchandise sales||$ 35,000|
|Cost of Goods Sold||10,500|
This income statement of Teddy’s Toy Shop, Inc. shows that the company performed well, making a net profit of $18,650 in 2018.
Income Statement Purpose #2
Through the income statement, the reader can comprehend how profitable the business is and what are the various business activities that the company has undertaken. We are also able to determine the amount of profit or loss that was generated over the course of a particular period of time. If one combines income statements from a consecutive number of years, a trend analysis could also be done to determine the change in revenue and expense items over time.
For example, gross profit is a figure which can be arrived at by deducting costs related to making and selling the company goods and services from the revenue or sales figure. The gross profit helps us understand how well the company uses the resources at hand and produces goods or services that customers are willing to pay for.
The first section of the income statement is usually presented as follows:
|Revenue||In USD millions|
|Cost of goods sold||12,870,000|
Further, we can also calculate operating profit, which is operating expenses subtracted from the gross profit figure. The operating profit is also known as EBIT or earnings before tax. This tells us the company’s profit before its interest and tax liabilities are accounted for.
Income Statement Purpose #3
Firstly, an income statement meets the requirements of different kinds of users. Let us discuss the usefulness of income statements for external users. As mentioned above, the income statement is available quarterly and yearly. For instance, the year-end income statements are useful to the following end-users:
Firstly, shareholders would be interested in knowing what the net profits of the company are for that year, as the dividends that they could receive are dependent on that.
Secondly, potential investors would like to assess the performance of the company to determine whether it is worth investing their money in the company. Similarly, if the income statement shows that the company is not profitable, investors will not put their money into such a venture.
Thirdly, some creditors would be interested in whether the company generates enough income to repay its debts.
For example, a potential investor would look at a three-year trend of the net profit of Teddy’s Toy Shop before deciding to invest. In this situation, the year-end income statement will come in handy.
Hence, potential investors, shareholders, creditors, etc. do not have access to information about the financial performance of the company. Lastly, their only source of information is the income statement.
Income Statement Purpose #4
Another set of end-users for whom the income statement is of use is the internal users. The management of the company works throughout the year, and hence, the annual income statements are not that useful. For them, quarterly income statements benefit them by focusing on the status of operations throughout the year. Further, to break down revenue and expense figures as per the business areas, department-wise statements may be prepared as well.
The managers and the board of directors also use the income statement to assess the entire business and decide how to operate it daily. It is a management tool as it helps them decide whether to discontinue a business segment, buy certain materials, lease or rent certain machines for production. Hence, all this depends on different aspects of the income statement.
For instance, if the interest expense is too high and is eating into the profits of Teddy’s Toy Shop, then the company would want to shift the location of the shop to an area with cheaper rent.
Conclusion – Purpose of Income Statement
An income statement is an important indicator not only for a company but also for its financial health. It basically helps the reader to determine whether, during the course of the year, the company has overall made a profit or incurred losses. A company that is not profitable will not attract investors, and even existing shareholders would start selling their shares. Not only the company management but also other stakeholders like potential investors, shareholders, banks, creditors, tax authorities, suppliers, etc. have one or the other use for the income statement.
To conclude, this article has been a guide to the Purpose of the Income Statement. Here we discussed some basic concepts and also the purpose of the income statement along with the help of examples. You may also take a look at the following articles: