Income Statement – Definition, Example & Components of Income Statement

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What is an income statement?

An income statement or earnings statement represents the income and expenses of the company for a specific period. It helps to calculate the net profit generated by the company after deducting all expenses and taxes. It is a financial statement also known as a profit and loss statement.

It is prepared at the end of every month, quarter, or year with a balance sheet and cash flow management. The service industry commonly used the term income statement instead of profit and loss statement. However, the purpose of both statements is the same, determining the net earnings of the company and the cost incurred to generate these earnings.

Why do companies prepare income statements?

Most of the Financial Statements are prepared at the end of every year. An income statement is more frequent as it prepares on a monthly or quarterly period to determine the expenses and revenues for proper cash management.

What is Cash management?

Cash management is an act of collecting, managing, and using the cash and cash equivalents of the company and ensuring that daily operations are running smoothly. A company cannot function properly only on its assets; they need to borrow the cash from the investors to manage the cash flow without interrupting the daily operations.

A company prepares the income statement for internal and external users.

Internal users: such as management and the board of directors use income statements and cash flow statements to analyze the company’s current standing and make the relevant decisions to improve the returns and decrease the expenses. An income statement also helps them with ineffective cash management.

External users: such as investors, creditors, lenders use the income statement to determine whether they should invest their money in the company or not. If they do, the income statement also helps them to analyze which area needs the cash flow to get better returns on their investment.

External users of the income statement:

  1. Creditors/lenders- creditors use the income statement to check if the company is profitable enough to repay their debts on time with interest. It also helps them to analyze the cash management of the company.
  2. Investors- Investors use this statement to determine the right time to buy or sell the company’s shares to make a profit. They also use the income statement to analyze the company’s ability to pay dividends.
  3. Competitors- It might be odd but very common for competitors to check each other’s income statements to find out the reasons behind their success. They can also use this statement to check where they are spending extra to improve their sales.

What Are The Components Of An Income Statement?

There are 3 sections in the income statement and all the components are divided into these sections. We will explain these components to you as they appear in the income statement.

  1. Revenue

This section holds all the earnings of the company for the specific period. Revenue is generally known as the income generated from the sales of goods and services for the relevant period. For example, Company XYZ sells cosmetic products and Company ABC is a teaching institute where they charge fees for their courses. 

Now, both companies are generating revenue by selling their goods (cosmetic items) and services ( teaching) for a sum of money known as the cost of goods sold (COGS) and fees. In both situations, the company is earning income.

Types of revenues are :
  • Revenue generated from the COGS
  • Service revenue or fee
  • Royalty
  • Rental 
  • Interest income
  • Commission income etc
  1. Expenses

To generate revenue, a company has to do some expenses known as a cost incurred. For example, Company XYZ needs to buy the raw materials to manufacture and sell the cosmetic products, they also need the equipment, human resource, packaging materials, and clinical trials before they launch the product in the market.

To generate revenue, they need to spend some amount on advertising and marketing to attract users. All these expenses are necessary to increase their sales. They also need to maintain a steady cash flow to smoothly run their daily operations.

There are two types of expenses in any business known as operating and non-operating expenses.

Operating expenses-

These are essential expenses and without them, a company cannot operate. You must have efficient cash management to deal with these expenses without any interruptions.

Types of operating expenses:
  • Salary and wages
  • Insurance
  • License fees
  • Rent
  • Research and development
  • Advertising and marketing
  • Office supplies
  • Maintenance and repair cost
  • Raw materials, equipment, and tools
Non- operating expenses-

These are not directly related to the business activities to generate revenues but if not done by the time they can harm the company’s revenue generation indirectly.

Types of non-operating expenses
  • Interest expense
  • Obsolete inventory charges
  • Loss on the deposition of assets
  • Cost of damages
  • Floatation cost
  • Restructuring expenses
  • Lawsuit settlement etc.
  1. Net Income

The last section of the income statement is net income. Net income is the total amount of the revenue generated by the company from the sales of goods and services after deducting the expenses and taxes of the relevant period.

Net income = Revenue – ( Expenses + Taxes )

Importance Of An Income Statement

Unlike other financial statements, an income statement helps to grow the business revenue in real-time. It allows the management to review their actions and construct better strategies while before the completion of goods and services.

How Income Statement Helps Business?

There are few ways an income Statement can help a business to become successful:

  1. Continuous Reports- Most of the financial statements are prepared at the end of the year but income statements. You can frequently get the reports on your strategies and see the result in real-time. You can change your methods to improve the sales and revenue generation with better and new methods instead of waiting for the result for a whole year.
  2. Knowing the expenses- Regular income statements help to control and monitor the operational and non-operational expenses. With the help of an income and cash flow statement, one can properly allocate the resources and manage cash flows. You can manage your current and future expenses.
  3. Reviewing the company’s standing- Income statement helps the investors, creditors, and competitors to get the overall analyses of the company. Financial institutions can also review the company’s standing and determine whether the company is worth investing in or not.

Conclusion

An income statement plays an important role in managing a company’s asset, liability, and cash flow statement. Every business involves planning for months or years and then making strategies to execute these plans to increase their sales and become a successful entrepreneur. 

Now, companies can use online software like Marg ERP to prepare all types of financial statements quickly and efficiently. These statements can help you to stay 1 step ahead of all the challenges. An income statement is helpful for management, creditors, lenders, and investors to understand the businesses standing and implement strategies accordingly. 

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