Building an Income Statement

This is the final publication in our series dealing with income statements.  This article is going to explain how to go about building an income statement.  And while you might never be asked to create an income statement, understanding the concepts behind net income, profitability, or corporate earnings will help you to better understand the financial health of a company.

Advantages and Disadvantages of the Income Statement

The income statement shows the investor what's left over after all of the company's expenses have been paid - net income.  This is an important measure of a company's overall profitability and that's why it's sometimes referred to as the "bottom line."

Market analysts spend a lot of time discussing net income because it's used to derive earnings per share - an important measure of profitability that is usually stated on a per share basis.  And since investors buy shares of stock, it's critically important for them to understand how much each share earned.

The down side of the income statement has to do with accounting adjustments which can distort net income in any given year.  For example one-time gains can overstate net income.  Net income also doesn't tell you anything about the future earning prospects of a company, its brand loyalty, or whether or not profits were merely the result of a change in an accounting method.

Simple Net Income Formula

As we did with some of the other financial statements we've built, we're going to build an income statement keeping the following ideas in mind:

• We need to cover two areas thoroughly in this statement - revenues and expenses - which can then be used to derive net income.
• We account for the money coming into the company from consumers / customers and this is called revenue.
• We also need to account for the money paid to sell products or services which are expenses of the company.
• We are not accounting for all of the money flows into and out of the company in a given year such as the money raised for financing an operation.  We can find that information in a statement of cash flows.

So the simple building blocks of the net income formula are:

+ Revenues
- Expenses
= Net Income

That means in order to build an income statement we really only need to be concerned with the accuracy of two pieces of information - revenues and expenses.

Income Statements

The information we're about to discuss from this point forward is a tutorial on how to build an income statement.  This statement is also known as a Profit and Loss Statement (P&L) and with large companies is sometimes referred to as the consolidated statement of operations.  We're going to cover each portion of this financial statement and provide examples to help you to better understand each concept.  And the end of this process we're going to provide you with a link to a file that demonstrates all of points we've discussed so you can visualize how they fit together.

Revenues

Revenue is a financial term that we're going to use to account for the money that a company receives from activities that include sales of products and / or services to customers.  Some companies use the term revenue and sales interchangeably while others use the term "sales" to describe the volume or number of products sold.  For example an electric utility might have sales of 40 billion kWh and revenues of $4.5 billion.

The revenues for any period of time are equal to the inflow of cash plus the increase in accounts receivable.  Companies recognize or "book" revenue when the goods or services are delivered to customers.  And as just discussed, revenues have a positive affect on net income.

Fortunately most companies track revenues in a very straightforward manner and they are usually stated as one line item which is simply labeled "revenues" or "operating revenues."

Expenses

In order to make money, most companies need to spend money and that's what an expense is all about.  Typically a company's expenses include everything from raw materials used to produce a product, or selling a service, through the depreciation on the equipment used to make a product.

When building an income statement we are generally going to group our costs into six categories:

1. Cost of Sales / Cost of Goods Sold
2. Selling, General and Administrative (SG&A)
3. Depreciation / Amortization
4. Other Operating Expense
5. Interest Expense / Interest Income
6. Income Taxes

Cost of Sales / Cost of Goods Sold

The cost of goods sold is all of the expenses a company incurs to make the product or provide the services offered.  This would include any raw materials, expenses associated with running the factory such as electricity, and labor used to manufacture a product or provide a service.

Selling, General, and Administrative Expense (SG&A)

When a company attempts to make a sale of a product or service they incur a selling expense.  The general and administrative expenses are those costs associated with running a company.  Activities such as running a human resources department or producing monthly performance scorecards are examples of administrative expenses.  Selling expenses would include advertising / marketing monies along with compensation paid to inside and outside sales persons.

Depreciation / Amortization Expense

When a company buys an asset that it intends to utilize over a relatively long period of time it's allowed to capitalize that purchase instead of expensing the cost.  This purchase then creates an asset on the balance sheet that the company is allowed to expense gradually over time.  This accounting treatment is allowed because it more fairly spreads the cost of the purchase over the serviceable life of the equipment.  This is the concept behind depreciation.

Depreciation allows a company to purchase an asset today and depreciate it over a longer period of time.  Depreciation expense is sometimes referred to as a non-cash expense because the company does not pay out money each year.  Remember, the money left the company's bank account on the day it paid for the asset.

By depreciating the asset over time, the company does not have to write off the expense in one year.  Instead it might depreciate the purchase over five years.  By doing so, the company does not sharply reduce net income in the year the asset is purchased.

The concept of amortization is nearly identical to depreciation except that amortization usually relates to intangible assets.  An example of an intangible asset might be goodwill associated with a popular brand name.

Other Operating Expenses

This category of costs are simply all of the other operating expenses incurred by a company that were not included in cost of goods sold, SG&A, or depreciation / amortization.  The important point here is to report expenses associated with the company's primary operation.
Stock analysts pay very close attention to the expenses a company reports in this category because companies sometimes label what amount to annual expenses as "one time" charges.  Examples of other operating expenses include restructuring expenses or the write down of assets.

Interest Expense / Interest Income

When a company places cash in short-term investments such as certificates of deposit, savings accounts and money market account the money in these accounts earns interest.  The interest earned on these types of accounts provides the company with a source of income that is accounted for on the income statement as interest income.

Interest expense, on the other hand, is the money paid to bondholders or lenders such as banks to pay for the interest portion of a loan payment.  The money associated with the loan is considered an asset of the company until it is used to purchase another asset such as plant machinery or is used to pay for other operating expenses.  The interest on the bond or loan is considered interest expense and is reported that way on the income statement.

Income Taxes

Income taxes - whether they are federal, state or local - are usually the last expense reported on the income statement before the calculation of net income occurs.  If you've worked in the past then you're familiar with the concept of taxes being levied on the income you earn - the same holds true for companies in the form of a corporate income tax.

Income taxes should not be confused with other "deductible" expenses such as property taxes which is an overhead expense and should be included as an operating expense.  Property taxes are sometimes categorized as Taxes Other than Income Taxes.

Income Statement Worksheet

Reviewing what we've learned up to this point; if we were to build a very simple income statement, it would look like the following:

Sample Income Statement

In the example above there are two common interim calculations that are performed before net income is shown:

• Operating Income - a measure of the earning power from a company's ongoing operations.  Operating income is sometimes referred to as operating profit or earnings before interest and taxes (EBIT).
• Income Before Income Taxes (IBIT) - also known as gross profit or ordinary profit.

Income Statement Example

As promised we're going to finish up this article and series by providing you with a link to an income statement spreadsheet.  In this worksheet you will find example information that we used throughout this tutorial including all of the necessary calculations.

In addition to the information above, our example worksheet also contains categories such as:

• Write Down of Assets - that can occur when an asset might have its useful life diminished for some reason or when the company decides the asset is not as valuable as once thought.
• Taxes Other than Income Taxes - that includes property taxes and some industry-specific regulatory taxes such as gross receipts and franchise taxes.

We also show you how the income statement is used to calculate earnings per share - one of the most important financial measures of a company's ability to remain a viable operation.

This article finishes up this three part series on the income statement which included the articles analyzing income statements as well as understanding net income.

About the Author - Building an Income Statement

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