Income Statement: Mathematical Explanation - QS Study

The income statement is one of the three primary financial statements used to assess a company’s performance and financial position (the two others being the balance sheet and the cash flow statement). The income statement summarizes the revenues and expenses generated by the company over the entire reporting period.

Example:

The income statement is also known as a profit and loss (P&L) statement, statement of earnings, statement of operations or statement of income.

The basic equation on which an income statement is based is:

Revenues – Expenses = Net Income

All companies need to generate revenue to stay in business. Revenues are used to pay expenses, interest payments on debt and taxes owed to the government. After the costs of doing business are paid, the amount left over is called net income. Net income is theoretically available to shareholders, though instead of paying out dividends, the firm’s management often chooses to retain earnings for future investment in the business.

Income statements are all organized the same way, regardless of industry. The basic outline is shown in the following example:

Income Statement for Company XYZ, Inc.

Why it Matters:

Anyone interested in active investing, picking stocks or investigating the financial health of a company must know how to read financial statements, including the income statement. The importance of the information contained in the income statement cannot be overemphasized.

A firm’s ability or inability to generate earnings over the long term is the key driver of stock and bond prices. Operating profit (EBIT) is the source of debt repayment, and if a company can’t generate enough EBIT to pay its debt obligations, it will have to enter bankruptcy or sell itself. Net income is the source of compensation to shareholders (owners of the company), and if a company cannot generate enough profit to compensate owners for the risks they’ve taken, the value of the owners’ shares will plummet. Conversely, if a company is healthy and growing, higher stock and bond prices will reflect the increased availability of profits.

Please note that earnings/net income/profits are not the same as cash or cash flow. It is possible for a firm to be profitable on the income statement, but not be generating cash flow, and vice versa. To see a company’s cash flow, you will need to examine its statement of cash flows.