A business's job is to produce something that society wants (shoes, haircuts, smartphones) and sell it for more than what it cost to produce. That's how profit is earned. From an investor's standpoint, this is the business's most important job. (After all, if the business isn't profitable in the long run, an investor/owner is losing money and will likely want to pull out of the business.)
The purpose of the INCOME STATEMENT is to measure the degree to which the business is selling its goods or services for more than what it costs to produce. Parties interested in a company's income statement include:
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Owners - since a company's profits become the owners' income, owners are highly concerned about their company's profit.
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Potential (future) investors or acquirers - this could include angel-, private equity- or venture capital investors. Because these people are would-be owners, they want to know that the company they're investing in will produce income for them (and not lose their money).
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Lenders or potential lenders - a company's profitability is directly correlated with its ability to pay back lenders (also called "creditors"). If a business isn't generating sufficient revenue, it will have trouble making payments to its creditors. So when a company applies for a loan, the would-be lender will want to see income statements.
An income statement shows profitability using three key metrics: revenues, expenses, and net income. Let's take a look at the income statement of WayneTech, a fictional computer company:
Revenue
Looking at the Sales revenue line item, we see that WayneTech sold $40,430,000 worth of computers to customers during 2016 (remember the numbers on the statement are shown in thousands). REVENUE is the total amount of money that a business earned selling its goods or services over a given period, before any expenses are taken out. Revenue is also commonly called "sales revenue" or just "sales", and it is the number of units sold ("volume") multiplied by the selling price of each unit ("price"), for each of its goods or services.
Total revenue helps us understand:
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How much demand there is for a company's good/service. The more demand, the more units it can sell, the greater total revenue will be. Revenue can also be an indicator of how good the company at *sales*. The better it is at selling, the more it "creates demand".
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How much market share the company has. A company's market share is equal to its total revenue, expressed as a percentage of the total revenue across the entire industry. For example, Apple's market share for smartphones equals its own revenue for smartphones divided by the sum of ALL smartphone revenue for ALL of the players in the industry.
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How much the company is capable of producing ("capacity"). Lots of revenue can indicate the company is selling lots of units, meaning it is highly "scaled".
Expenses
EXPENSES are the costs a business incurs as it produces and sells its product to earn revenue. WayneTech's income statement shows total expenses of $28,550,000 during 2016. They include:
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the cost of physically producing the computers they sold, including materials, parts and labor; this is known as the cost of goods sold expense (aka "COGS expense")
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the costs associated with their sales efforts and administrative activities (including receptionists, administrative assistants, the HR department, their accountant, etc.); these costs get roled up into what's called the selling, general, and administrative expense ("SG&A")
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the cost of developing new products, known as the research and development expense ("R&D")
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the cost of borrowing money from the bank--the interest expense.
These expenses are added up and then deducted from revenue, which leaves us with pretax income. The government then takes a percentage of these earnings--the tax expense. Once taxes are removed, we're left with net income.
Net Income
NET INCOME is the remaining money after expenses are subtracted from revenue. It is the profit to which the company's owners are entitled. Net income is also referred to as earnings or "the bottom line" (both literally and figuratively, since it appears near the bottom of the income statement and is what investors are often most concerned with).
Sometimes, a company's net income is negative. This is referred to as a loss. A loss occurs when the company's expenses are bigger than its revenues.
Retained Earnings
Suppose you owned your own business (you are both manager and equity owner). At the end of each accounting period you'd tally up your business's net income, and you'd have a choice: take the profits home and thow a party, or reinvest them into the company to keep it growing (you could, for example, use the funds to expand your advertising campaign, hire more help, etc.).
The fundamental income statement equation.
RETAINED EARNINGS are the total profits that the company has earned (over its lifetime) that have not yet been distributed to the owners/shareholders. Usually, the company begins the accounting period with some amount already in retained earnings that they accumulated in prior years. As the period progresses, the firm earns revenue and pays expenses. At the end of the accounting period, the company determines its net income. Some of this net income gets distributed to shareholders, and the rest gets reinvested and added to retained earnings. Here is the equation that determines retained earnings at the end of the period:
The fundamental retained earnings equation.
Of course, equity investors want to see how much of the company's profits they'll receive--in the form of dividends, or sometimes called "distributions"--and how much will get "plowed back" into the company as retained earnings. In the case of a public company (one whose shares can be bought by anyone), the company's board of directors decides this.
Often, the company produces a document called the Statement of Retained Earnings to show this (I've reproduced one for our fictional company below). Other times, this information will be shown at the bottom of the income statement.
So the income statement is instrumental in helping external parties, like investors and creditors, see how *profitable* a company is. At the end of the day, the company needs to sell its product for more than it cost them to produce, otherwise, it loses money. (We also saw how the profits earned by the company can either be distributed to owners/investors or pushed back into the company as retained earnings.)
So while the income statment can help us see the firm's effectivness at managing the regular expenses of *running* the business, it doesn't tell us a lot about the money required to *start* the business. For example, a restaurant's income statement would tell us the cost of the napkins, straws, and other supplies used in the process of feeding customers, but it doesn't tell us how much funding the shop needed for say, the refrigerators or the furniture. This latter information is conveyed on the balance sheet, which is covered in the next lesson...
To test your understanding of the concepts, below is a very short downloadable quiz. A separate document contains the solutions for you to compare with:
Mike Friedmann
Mike is a former financial analyst and consultant at IBM and a former economic research associate at Harvard Business School. He is now a private instructor to busines students from Harvard, Columbia, NYU/Stern, and about 40 other schools, and a private instructor/coach to entrepreneurs, investment banking analysts, real estate professionals, attorneys and other executives.