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Resources - Applied Finance / Chapter 9

Dissecting the Income statement

Income statements

Overview

In the prior chapters, we learned about the accounting process leading to the preparation of financial statements. Now, we will learn in greater detail about the two major financial statements, the income statement, also known as the profit and loss statement (P&L) and the balance sheet.

Income Statements - An Overview

The financial statements of an entity report its financial position and performance during the period covered by the statements. The two major financial statements, the balance sheet and the income statement and their preparation have already been covered in previous chapters. In the current chapter, we will focus on the income statement, its function and introduce the major items which comprise the income statement.

The income statement or the profit & loss statement summarizes and reports the entity’s incomes, expenditures and profitability over the period covered by the report. Most organizations prepare quarterly as well as annual income statements. In the case of publicly traded companies, the income statements are available to the public on corporate websites as well as on financial and trading-related websites such as moneycontrol, yahoo finance etc.

To illustrate the concept with an example, we will be using the income statement of Tata Steel Limited (TSL) for the year 2021-22 to explain the different components of the income statement. You can access the income statement from the annual report (page no. 293) provided on the tata steel website1.

The income statement is important for both internal and external users of the company. The internal users may include managers and the board of directors of the company who use the income statements to understand the profitability of the business, plan and manage expenditures, and budget, to ensure sufficient cash flows to meet the needs of the business.

The external users include investors who rely on income statements for important metrics such as revenues, revenue growth and profitability which enable them to predict whether the company will grow in the future and be profitable and thereby make investment decisions. Creditors also use income statements to check if the company is likely to be able to meet its repayments in a timely manner while there are also tax authorities who use income statements to figure out the tax due by the company as well as governments, regulators and competitors who are concerned about the company's performance, growth and profitability.

Components of the Income statement

While the exact format and components of an income statement vary depending on regulatory requirements, the nature and complexity of the business, the industry of operation etc, the major components of the income statement are detailed in the section below:

  • Revenue or Income

    The income statement typically starts by listing the gross sales made by the company during the period. Revenue is typically broken up into operating revenue which is the revenue gained by a company by performing its primary activity and the other is non-operating revenue which is the revenue gained from other sources.

    For example, TSL reported an operating revenue of INR 1,29,021.35 Cr from the sale of steel and other products in 2021-22. TSL also reported other income of INR 1,452.02 Cr, income primarily from investments.

  • Expenses

    The various expenses incurred by the company are the next major item detailed in the income statement. The expenses are typically separated across several categories for ease of understanding and comparison. Like revenues, expenses may also be divided into two major categories – operating expenses generated as a result of the company’s core business expenses and other expenses/non-operating expenses. Some of the major categories of expenses are detailed below:

    • Raw material expenses – The cost of materials consumed for the production of goods and services (Item IV(a) in TSL P&L)
    • Purchase of stock-in-trade – Cost of materials purchased for trading/resale (Item IV(b) in TSL P&L)
    • Employee expenses – Expenses incurred towards the upkeep of employees including salaries, retirement benefits etc. (Item IV(d) in TSL P&L)
    • Finance costs – Cost incurred on borrowings including interest (Item IV(e) in TSL P&L)
    • Depreciation and amortization expenses – The costs of fixed assets which are used for many years are expensed each year over the life of the asset (Item IV(f) in TSL P&L).

      For instance, consider a machine which will operate for 10 years and costs INR 10 Lakh. Since the machine is used every year and is not an expense incurred for the production of goods sold in the first year alone, expensing the entire amount in the first year itself would violate the matching principle. Hence, the expense is spread out over the 10 years the asset is actually used. Such expenses for tangible assets are known as depreciation and for intangible assets such as patents, copyrights, software etc. as amortization

    • Cost of Goods Sold (COGS) – The total cost which can be directly associated with producing and selling the goods/services sold by a company is referred to as COGS. It includes the cost of materials, labour & more that is used to create the products as well as selling costs, distribution costs etc. associated with selling the products. However, costs which are general to the business and cannot be directly attributed to a specific item are not included in the COGS. Also, COGS is not directly available in the income statement but it can be calculated from income statement items.
  • Profits or Margins

    Another important item tracked by the income statement is the different profitability metrics of the company. The profitability metrics are widely followed by the different stakeholders of the firm.

    • Profit before tax (PBT) – The profit before tax tracks the taxable profits made by the company and is the difference between the incomes and the expenditures of the company over a period (Item VII in TSL P&L)
    • Profit after tax (PAT) – PAT tracks the net profit made by the company and is PBT lesser taxes for the period
    • Gross profit/Gross Margin – Gross profit is the profit made by a company after deducting the direct costs associated with making and selling its products/providing its services. It can be calculated as the revenue after subtracting the COGS.

Closing summary

All the aforementioned cover the main components of the income statement. However, the exact terminologies used will vary across different companies based on their operational characteristics and accounting choices. Now that we have covered the preparation and interpretation of the income statement, as an exercise, you can compare the financial statements of a few service companies and companies that manufacture goods to see how they vary from each other.