Building an Income Statement

8/4/2019 Building an Income Statement

1/6

Building an Income Statement

This is the final publication in our series covering the topic of income statements. Thisarticle is going to explain how to go about building an income statement. While youmay never be asked to create an income statement, understanding the concepts behind

net income, profitability, or corporate earnings will help you to better understand thefinancial 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'sexpenses have been paid: net income. This is an important measure of a company'soverall profitability, and that's why it's sometimes referred to as the "bottomline."Additional Resources

Understanding Cash Flow

Evaluating Cash Flow Results

Building a Cash Flow Statement

Understanding Net Income

Profit Margin

Analyzing the Balance Sheet

Analyzing Income Statements

Building an Income Statement

Simpsons Paradox and Investing

Financial versus Managerial Accounting

Market analysts spend a lot of time discussing net income because it's used to deriveearnings per share, which is an important measure of profitability. Since investors buyshares of stock, it's critically important for them to understand how much each shareearned.

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


2/6

Simple Net Income Formula

As we did with some of the other financial statements, we're going to build an incomestatement 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, andthis is called revenue.

We also need to account for the money paid to sell products or services, which areexpenses of the company.

We are not accounting for all of the money flows into and out of the company in a givenyear such as the money used 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 only need to be concerned withthe 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 tobuild an income statement. This statement is also known as a Profit and LossStatement (P&L), and with large companies is sometimes referred to as theconsolidated statement of operations. We're going to cover each portion of this financialstatement, and provide examples to help you to better understand each concept. At theend of this process, we're going to provide you with a link to a file that demonstrates allof the points we've discussed. This allows you to visualize how these concepts fit

together.

Revenues

Revenue is a financial term that we're going to use to account for the money that acompany receives from activities that include sales of products and / or services tocustomers. Some companies use the term revenue and sales interchangeably, whileothers use the term "sales" to describe the volume or number of products sold. For


3/6

example an electric utility might have sales of 40 billion kWh, and revenues of $4.5billion.

The revenues for any period of time are equal to the inflow of cash plus the increase inaccounts receivable. Companies recognize or "book" revenue when the goods or

services are delivered to customers. As just discussed, revenues have a positive effecton net income.

Fortunately, most companies track revenues in a very straightforward manner and theyare usually stated as one line item, which is normally labeled "revenues" or "operatingrevenues."

Expenses

In order to make money, most companies need to spend money. That's what anexpense is all about. Typically, a company's expenses include everything from rawmaterials used to produce a product, or selling a service, through the depreciation onthe equipment used to make a product.

When building an income statement, we are generally going to group our costs into sixcategories:

Cost of Sales / Cost of Goods Sold

Selling, General, and Administrative (SG&A)

Depreciation / Amortization

Other Operating Expenses

Interest Expense / Interest Income

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 aproduct 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 sellingexpense. The general and administrative expenses are those costs associated withrunning a company. Activities such as running a human resources department or


4/6

producing monthly performance scorecards are examples of administrative expenses.Selling expenses would include advertising / marketing monies, along withcompensation paid to inside and outside salespersons.

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. Thispurchase then creates an asset on the balance sheet that the company is allowed toexpense gradually over time. This accounting treatment is allowed because it spreadsthe cost of the asset over the serviceable life of the equipment. This is the conceptbehind depreciation.

Depreciation allows a company to purchase an asset today, and depreciate it over alonger 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, themoney 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 theexpense in one year. Instead, it might depreciate the purchase over five years. Bydoing so, the company does not sharply reduce net income in the year the asset ispurchased.

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

Other Operating Expenses

This category of costs are all of the other operating expenses incurred by a companythat were not included in the cost of goods sold, SG&A, or depreciation / amortization.The important point here is to report expenses associated with the company's primaryoperation.

Stock analysts pay very close attention to the expenses a company reports in thiscategory because companies sometimes label what amount to annual expenses as"one time" charges. Examples of other operating expenses include restructuringexpenses 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 accounts, the money in these accounts earns


5/6

interest. The interest earned on these types of accounts provides the company with asource 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 suchas 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 it is used to pay for other operating expenses. Theinterest on the bond or loan is considered interest expense, and is reported that way onthe income statement.

Income Taxes

Income taxes, whether they are federal, state, or local, are usually the last expensereported on the income statement before the calculation of net income occurs. If you'veworked 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 incometax.

Income taxes should not be confused with other "deductible" expenses such as propertytaxes, 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 incomestatement, it would look like the following:

Sample Income StatementRevenues $100Less:Cost of Goods Sold $35Selling, General and AdministrativeExpense

$15

Depreciation $10Other Operating Expense $5Total Operating Expense: $65Operating Income $35Interest Expense $5

Income Before Income Taxes $30Income Tax Expense $9Net Income $21


6/6

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

Operating Income - a measure of the earning power from a company's ongoingoperations. 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 this article, and series, by providing you with a link toan income statement spreadsheet. In this Excel worksheet, you will find exampleinformation that we used throughout this tutorial, including all of the necessarycalculations.

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

Write Down of Assets - that can occur when an asset might have its useful lifediminished for some reason, or when the company decides the asset is not as valuableas 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 viableoperation.

Documents

Building an Income Statement