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As a sophisticated reader of financial statements, we will assume you have carefully read the accountants report and scrutinized the balance sheet of the company you are reviewing. The time has come to start in on the income statement.

As we discussed in the prior article, the balance sheet is the statement of the financial strength of the company. The income statement is a statement of the increase or decrease in strength of a company.

Other names for the income statement include "Statement of Income," "Statement of Operations," and "Statement of Earnings". A company with losses might title the document "Statement of Loss". The term "Profit and Loss" is obsolete and is considered slang by accounting professionals. If a company is using the cash method of accounting instead of accrual, the name might be "Statement of Receipts and Disbursements Arising from Cash Transactions," or "Statement of Income-Cash Basis".

The income statement measures the revenues, expenses, gains and losses, for a given period of time. Revenues are the inflows resulting from a company's operations. Expenses are the outflows resulting from a company's operations. Gains and losses are the results of a company's transactions that are not related to the company's operations. Income statements typically are prepared for periods of one month, quarter, semi-annual, or annual periods.

A typical format for the income statement might be as follows:

Sales - Presents revenue from service or product sales, less product returns and allowances.

Cost of Sales - Generally shows the costs of inventory sold. For construction contractors, cost of sales represents the direct materials, labor, sub-contract, and other construction costs. Most service businesses, such as doctors, lawyers, or appraisers, do not use a cost of sales presentation.

Gross Profit - Is equal to sales less cost of sales.

Operating Expenses - Are the selling and administrative expenses of the business.

Income From Operations - Is equal to gross profit less operating expenses.

Other Income and Expense - Includes income, expenses, gains, and losses that management has decided to keep separate from operations.

Income Before Tax - Is equal to income from operations, plus other income, less other expense.

Provision for Income Tax - Is the amount of tax the company expects to pay on the income.

Net Income - Is the income after subtracting the provision for income tax.

After determining net income, most companies integrate a Statement of Retained Earnings to the income statement. Recall that retained earnings is equal to the net income the company has earned from inception, less distributions of income to owners.

For current year operations, the presentation of and formula for retained earnings is:

Net Income

Plus balance of retained earnings at beginning of year

Less dividends or distributions paid

Equals ending retained earnings

The statement of retained earnings applies only to corporations. If the company is a sole proprietorship, the equivalent statement is a statement of changes in owner's equity. In a partnership, the equivalent is Statement of Changes in Partner's Equity.

Earnings Per Share - Are calculated for public entities. Privately held companies do not typically calculate earnings per share.

Generally Accepted Accounting Principles (GAAP)require the use of accrual accounting. This means that revenues are recorded when earned. For instance, a distributor will recognize revenue when a product is shipped, as opposed to when the sales order is taken, or when the cash payment is received.

Accrual accounting requires matching of expenses with related revenue. For example, a company should show the cost of the sale and sales person commission in the same accounting period as the related revenue.

How to Analyze an Income Statement

In order to digest an income statement, all accounts should be calculated as a percentage of sales.

After calculating percentage of sales for all accounts, you need to compare the current income statement, line by line, to other income statements. Income statements to use for comparison might be the same period in prior years, comparison to budget, or comparison to industry averages.

By comparing the current month, quarter, or year to the equivalent period in prior years, you can observe trends. Another format for revealing trends is to show the last six months' income statements side by side. Keep in mind you should analyze both actual dollar amounts and percentages.

By comparing actual to budget you can determine if you are on course with your plans. We find that the lack of written budgets indicates lack of planning. Strong management requires good planning and budgeting.

By comparing your income statement to industry averages, you can gain important understanding of your business. Industry averages are available from various sources such as Robert Morris and Associates and trade associations.

When you are comparing your income statement to other income statements, consider each account line by line. Do not limit yourself to only looking at gross sales and net income. Pay particular attention to the percentages, or ratios. The most important ratios for most businesses are gross profit, operating expense, and net income. Other important percentages are depreciation, interest expense, warranty expense, labor costs and owner's compensation.

With time, you will become acquainted with the dollar amounts and ratios on the income statement. You will know instinctively how to look for trends, unusual balances, and find out "where the action is".

In other articles we explore ratio analysis in greater detail and we discuss footnote disclosures.

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