Using the Income Statement

The primary purpose of the income statement is to demonstrate the profitability of an organization's operations over a fixed period of time by illustrating how proceeds from operations (i.e. revenues) are transformed into net income (profits and losses).

Compared to the balance sheet and the cash flow statement, the income statement is primarily focused on the actual operational efficiency of the organization. The balance sheet discusses leverage, assets, funding, and other aspects of the organization's existing infrastructure. The cash flow statement is primarily a description of liquidity. The income statement, however, is ultimately about how a given revenue input can be converted to profitability through assessing what is required to attain that revenue.

Assessing Efficiency

The income statement is relatively straight-forward. As an investor or a manager, the simplest way to view each section is by focusing on efficiency. An optimally efficient organization will have higher margins in the following areas:

Profit margin: A higher net profit as a proportion of sales indicates an overall higher capacity to capture returns on revenue. Profit margin is one of the first aspects of an organization a prospective investor will look at when considering the overall validity of a company as an investment. This is calculated as:

${\displaystyle {\frac {\mbox{Net Profit}}{\mbox{Net Sales}}}}$

Operating Margin: Another useful indicator of profitability is operating income over net sales. Operating income subtracts the cost of goods sold (COGS) alongside selling, general, and administrative expenses (SG&A), leaving the overall profit before taxes and interest on financial debt. Comparing this to the overall profit margin can give useful indications of reliance on debt. It's calculated as:

${\displaystyle {\frac {\mbox{Operating Income}}{\mbox{Net Sales}}}}$

Another useful indicator is the gross margin. This essentially demonstrates the added value of each unit of sales, as it focuses exclusively on the impact of the cost of goods sold (COGS). COGS represents the costs incurred (directly) from materials, labor, and production of each individual unit. This can be a great indicator of how scalable an operation is, and the relative return an organization will see as they achieve growth.

${\displaystyle {\frac {\mbox{Net Sales -- COGS}}{\mbox{Net Sales}}}}$

Income Statement Example

This is a simple example of the typical line items on an income statement.

This is a simple example of the typical line items on an income statement.