Definition of Income Statement
All publicly-traded companies are required to release an income statement either quarterly or yearly. There are three major items that complete the structure of an income statement – revenue, expenses, and net profit. It shows the company’s performance over a particular period of time. In other words, it is a company’s profit and loss account. There are two sections in an income statement – the operating section and the non-operating section. 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 that are unrelated to the regular business activities of the company.
Purpose of Income Statement
Below are the Some Income Statement Purpose which are 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. Various stakeholders are interested in knowing how well the company is functioning, which are the business activities that it has undertaken, what are 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 as it made a net profit of $18,650 in the year 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 was to put together income statements from a consecutive number of years, a trend analysis could be done as well, 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 of the company goods and services from the revenue or sales figure. The gross profit helps us understand how well the company is using the resources at hand and producing 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 what is the company’s profit before its interest and tax liabilities are accounted for.
Income Statement Purpose #3
An income statement is used to meet the requirements of different kinds of users. First let us discuss, the usefulness of income statements for external users. As mentioned above, the income statement is available quarterly as well as 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. If the income statement shows that the company is not profitable, investors will not put their money in such a venture.
Thirdly, some creditors would be interested in knowing whether the company is generating enough income to pay back 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 it. In this scenario, 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. 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 are 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 give them the benefit of focusing on the status of operations throughout the year. Further, to break down revenue and expense figures as per the business areas, there may be department wise statements prepared as well.
The managers and the board of directors also use the income statement to assess the entire business and make decisions about how to operate it daily. It is used as a management tool as it helps them decide whether to discontinue a business segment, to buy certain materials, to lease or rent certain machines for production. 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 of a company’s 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.
This has been a guide to the Purpose of the Income Statement. Here we discussed some basic concepts and the Purpose of the Income Statement along with the help of examples. You may also take a look at the following articles: