5.1 The Income Statement

Functionality of the Income Statement

The income statement shows a firm’s performance over a specific period of time. The statement helps financial statement users understand the sales generated during the period and the expenses incurred to generate those sales. If the expenses are smaller than the sales, the net result is profitability, or net income, rather than a net loss.

Breaking the income statement down into smaller pieces provides a more transparent view of the firm’s performance, allowing users to see more clearly what areas of the business incurred expenses. This is helpful to management in driving improvements and to outside users in assessing performance.

Sales and Gross Profit

The first section of the income statement begins with sales. Though financial statements are required to follow a certain format, account names can differ slightly from one firm to another. You may see the first line, often referred to as the top line, called sales, sales revenue, revenue, service revenues, and other similar titles. All of these titles are meant to reflect the sales generated by selling product to customers in the day-to-day business. On Clear Lake’s income statement in Figure 5.2, we see its top line referred to as Sales.

Income from items that aren’t common to the firm’s day-to-day business are reported as gains and losses, and they are reported further down in the income statement rather than at the top line with its regular, core business activities. This is to ensure that anomalies like selling a machine or a loss on retiring a bond don’t mislead financial statement users as to the general performance of the firm and impact their assumptions of future results.

Firms report their sales and any reductions to sales separately on the income statement. They begin with gross sales, which includes all sales to customers. Clear Lake reported gross sales of $105,000 last year and $126,000 this year. The next line is sales returns and allowances, which is deducted from gross sales in order to find net sales. Clear Lake’s sales returns and allowances were $5,000 and $6,000 respectively, leaving the company with net sales of $100,000 and $120,000 respectively

Next, the cost of goods sold (COGS) is deducted from net sales in order to arrive at gross profit. (It is customary to refer to sales minus COGS as gross profit because gross margin $=$ gross profit/sales.) Cost of goods sold includes the costs directly involved in making the product that was sold during the period. Common examples of costs included in cost of goods sold include direct labor, direct materials, and the overhead assigned to the product in production. For a service business, this would include its direct labor and any materials used to deliver its services. For a retail firm like Clear Lake Sporting Goods, this would include the costs of all the goods it purchased for resale. Clear Lake’s COGS is seen at $50,000 and $60,000 for the prior and current years. Note that different types of companies will have different types of costs deducted in their Cost of Goods section. Clear Lake Sporting Goods is a retailer, or merchandiser that buys good to resell. Their cost of goods includes the cost of goods they purchased to resell. In the link to learning, you will explore Apple, a technology manufacturer. Their cost of goods would include the cost to manufacture the goods they sell. Another type of firm is a service firm. A law office, for example, would include primarily the cost of labor in their cost of services.

Gross profit is a reflection of how profitable the firm’s performance was in its core business function. It includes only the core business and direct costs of performing that business. If the company were a shoe company, gross profit would show how profitable the company was in simply making the shoes it sold. If it were a bakery, gross profit would show how profitable the company was in simply baking the goods it sold. Gross profit shows financial statement users how effective the business is at generating top-line profits on their core business function. It does not reflect the performance of other areas of the firm such as other operating costs to support the direct production process, indirect costs, and financing.

For Clear Lake Sporting Goods, we see its gross profit in Figure 5.2. The company earned $50,000 of gross profit $(\$\mathrm{100,000} – \$\mathrm{50,000})$ the prior year and $60,000 in the current year $(\$\mathrm{120,000} – \$\mathrm{60,000})$.

Figure 5.2 Income Statement through Gross Profit Line

Income from Operations

Gross profit is a very helpful measure, but it is only the first of several provided by the income statement. After gross profit is calculated, other operating expenses are deducted in order to calculate the firm’s income from operations, also commonly called operating income. Common operating costs found in this section include building rent and utilities, property taxes, wages and salaries, and other overhead costs. In Figure 5.3, we can see Clear Lake’s operating expenses. To sell its hunting and fishing equipment in the current year, Clear Lake Sporting Goods paid rent for its building ($5,500) and utilities for its retail and warehouse spaces ($2,500); recorded depreciation on equipment, buildings, and store furnishings (shelves, racks, etc.) ($3,600); and paid salaries to its indirect employees in accounting, purchasing, and human resources ($5,400). The company’s operating expenses are deducted from gross profit to arrive at operating income

While gross profit reflects only how profitable the firm was in making its core product, operating income reflects how profitable the firm’s daily operations were as a whole. This still does not include other miscellaneous items outside the scope of a firm’s normal business. Just as the name implies, it shows income from the core operations of the firm.

Figure 5.3 Income Statement through Income from Operations

We can see that the company was able to generate $\$\mathrm{20,000} (\$\mathrm{120,000}-\$\mathrm{100,000})$ more in net sales in the current year than the prior year. However, it only generated $\$\mathrm{10,000} (\$\mathrm{60,000}-\$\mathrm{50,000})$ in gross profit and $\$\mathrm{5,000} (\$\mathrm{43,000}-\$\mathrm{38,000})$ of additional operating income. Further investigation shows that while net sales increased, so did the direct costs of its goods (COGS) and its operating expenses.

We will further explore how to assess each of these expenses later in the chapter using common-size analysis. Common-size analysis reflects each element of a financial statement as a percentage of the base. In the case of the income statement, the base is net sales. Here we would see that COGS was 50 percent of net sales in both the current $(\$\mathrm{60,000}/\$\mathrm{120,000})$ and prior year $(\$\mathrm{50,000}/\$\mathrm{100,000})$, indicating there wasn’t any significant change in performance we could detect from the information provided in the income statement.

Net Income

Finally, we move on to net income, or what is commonly referred to as the bottom line. Net income (or loss) reflects the net impact of all financial transactions for the firm, including those that are caused by events outside the normal course of business. The most common items deducted from operating income to arrive at net income include interest expense, gains/losses, and income tax expense. Remember, gains and losses are those that result from unusual transactions outside the normal course of business. Examples include selling a piece of old equipment or a loss on retiring debt.

We can see in Figure 5.4 that Clear Lake Sporting Goods has outstanding debt, so it incurred interest expense of $2,000 in the current year and $3,000 the prior year. Since it recorded net income (not a loss), it must also record income tax expense of $6,000 in the current and $5,000 in the prior year.

Figure 5.4 Comparative Year-End Income Statement

EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization)

Now that we have a full income statement, we can look at another commonly used measure of financial performance called EBITDA. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Amortization is similar to depreciation. It is the spreading of the cost of an intangible asset over the course of its useful life. Intangible assets are long-term assets that lack physical substance, such as patents and copyrights.

Since EBITDA removes the effects of noncash items from the net income equation, it is considered a useful measure in assessing the cash flows provided by operating activities. We will assess cash flows using the statement of cash flows and various other cash flow measures later in this chapter as well.

As shown in Figure 5.5, Clear Lake Sporting Goods’ EBITDA in the prior year was

and in the current year was

Figure 5.5 EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization)