Understanding Income Statement Components and Format | CFA Level I FSA
Welcome back! We now move on to an in-depth examination of the various financial statements, starting with the income statement.
The income statement is a crucial piece for an analyst to make forecasts of the future earnings of a firm. As such, an analyst should know the key components of an income statement, how they are prepared, and the techniques to analyse the statements.
Components of the Income Statement
The income statement communicates how much revenue a company generated during a period, and the expenses it incurred in connection with generating that revenue. The key outcome from the income statement is the net income, which is a key metric of the company’s profitability.
Under both IFRS and US GAAP, the income statement may be presented as a separate statement, followed by a statement of comprehensive income that begins with the profit or loss from the income statement.
Investors examine a firm’s income statement for valuation purposes, while lenders examine it for information about the firm’s ability to make the promised interest and principal payments on its debt.
The basic equation underlying the income statement, ignoring gains and losses, is:
Revenues and Expenses
Revenues are the amounts reported from the sale of goods and services, in the normal course of business. So for a shoe retailer, revenue is recorded as the price of the shoes sold to a customer.
- Cost of goods sold – the direct costs attributable to the production of the goods.
- Depreciation expenses – the reduction in long-term assets value recorded during the period.
- The amount of interest paid to debt holders during the period.
- The amount of taxes recorded during the period.
What we have described so far are considered core operations of a company. Companies can make money outside their core operations.
Other Income, Other Expenses, Gains, and Losses
For example, a retailer may have unused warehouse space that is rented out for some side income. This revenue is classified under other income, and any expenses made outside of core operations is regarded as other expenses.
The income statement also includes economic gains and losses through investments. Gains and losses may also result from ordinary business activities. Taking the example of the unused warehouse, if the company decides to sell it off, the difference between the sales price and the book value is reported as a gain or loss on the income statement.
If a firm has a controlling interest in a subsidiary, the entire net earnings of the subsidiary are reported in the income statement of the parent.
In cases where there are minority shareholders in the subsidiary, this portion of the net income should not be attributed to the parent.
Formats of the Income Statement
A firm can present its income statement using a single-step or multi-step format.
In contrast, a multi-step statement uses multiple subtraction steps to arrive at the net income.
It segregates the operating items from the non-operating items. The multi-step income statement also shows the gross profit, operating income, income before tax, and income from continuous operations. This allows an analyst to study the company’s gross profit margins and profits from core operations. It also allows the analyst to study the effects of finance costs and taxes on the company’s performance.
And that’s all for this lesson! Now that we have an overview of the income statement and the items that go into it, we shall go in-depth into each of the major items of the income statement. We shall begin with revenue in the next lesson.