The Income Statement (known historically in the UK as the Profit and Loss Account) details a company’s financial performance resulting from its day-to-day operations over a defined period of time (typically one year). It shows the income generated from a firm’s operations over a period of time; the expenses relating to those operations; and the net profit (also known as the ‘bottom line’ as it appears at the bottom of the Income Statement). Different companies may report their Income Statements in slightly different ways. The below example provides a simplified illustration of an Income Statement, including an outline of the key elements.
- Net Profit: refers to the amount of money remaining from the revenue after all related expenses have been subtracted.
- Cost Of Goods Sold (COGS): includes the direct costs associated with each sale made (usually variable costs). For example, if a firm sells 1,000 desks, such costs would include the direct costs associated with manufacturing each desk (e.g. the wood used).
- Selling, General & Administrative Costs (SG&A): includes general expenses that do not directly relate to each individual sale (usually fixed costs). Examples include overheads such as office rental payments and utility bills and purchases of assets.
Certain costs may be difficult to neatly categorise within COGS or SG&A. For example, the cost of labour may not directly correlate with the number of sales that are made. Wages (at least in the short-term) will still have to be paid even if demand (and consequently output) decreases. However, a reduction in sales (and output) could eventually lead to redundancies, indicating that labour costs may to some extent correlate with the number of sales made in the long-term. In recognition of this, certain costs can be categorised (within reason) at the discretion of the person creating the accounts.
Depreciation and amortisation account for the depletion in value of company assets over time. Depreciation and amortisation are not technically cash expenses; they should be thought of more as economic expenses associated with the running of a business. Depreciation applies to tangible assets, whereas amortisation applies to intangible assets (such as patents owned by pharmaceutical companies or software used by technology companies, which will eventually become out-dated).
- Depreciation: refers to the decrease in value of tangible (physical) assets over time. An older asset that has been regularly used will typically be worth less than a newer version of the same asset, as it is more likely to break or work with reduced efficiency. Accordingly, accountants typically record an asset’s estimated loss in value (which has occurred as a result of the use of that asset over the accounting year) as a cost in the company’s accounts. For example, assume a tractor owned by a farmer has an expected useful life (before it is likely to mechanically break or operate with unsatisfactory inefficiency) of approximately 30 years. If it costs £30,000 new, it is more sensible for accountants to reduce the value of the asset gradually year on year rather than state that the asset’s value is £30,000 until the day before it is 30 years old, then the very next day record its value as £0. In this example, the cost of depreciation (on a straight-line basis) would be £30,000 / 30 = £1,000 per year for 30 years.
- Amortisation: refers to the decrease in value of intangible assets over time. For example, a patent may decrease in value as its expiry date approaches. Accordingly, accountants typically spread the decrease in value of intangible assets (as a cost on the Income Statement), for accounting purposes, over the duration of the asset’s useful life.
It should be noted that interest payments are deducted from the revenue before tax is calculated. Accordingly, the larger the interest payments a company must make, the smaller its tax bill becomes (tax is calculated based on earnings left over after interest payments have been deducted). The Income Statement is often followed by a separate statement of shareholders earnings, which details dividend payouts made from the net profit.
In case studies, you may be presented with basic financial accounts from the current year and the previous few years. If this is the case (depending on the issues you are asked to consider), start by analysing the profit figures to see how the company’s performance has changed.
- If profits have increased year on year, this could indicate that the company could continue to thrive. Conversely, if the net profit has decreased, this could, on the face of it, suggest it may eventually run into financial difficulties. At this stage you should then try to discover (through looking at the accounts) why the net profit has decreased.
- For instance, a decrease in revenue (which could cause a corresponding decrease in net profit) could suggest consumers are purchasing less of the company’s products, which in turn may indicate that new competitors have entered the market (or that existing competitors have developed a similar or superior product, perhaps at a more favourable price).
- If the revenue has remained the same or increased but the net profit has decreased, look at whether the costs have increased (which would also decrease the net profit). If costs have increased, does this suggest the company has failed to implement effective mechanisms to control costs (in which case think of potential solutions, for instance laying off staff or looking for cheaper suppliers?) or has the cost of raw materials increased (e.g. if the company produces apple juice, has the price of apples increased)? Alternatively, has the company made an investment (for instance purchased a factory) that has increased costs in the current year (and thus reduced the net profit) but may well contribute to an increase in net profit in future years?
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By Jake Schogger - City Career Series