How to Read an Income Statement

What an Income Statement Shows

An income statement, also called a profit and loss statement or P&L, summarizes a company's revenues, costs, and resulting profit or loss over a specific period of time, such as a quarter or a year. Unlike a balance sheet, which shows a snapshot of what a company owns and owes at a single moment, an income statement shows activity across a stretch of time, more like a video of financial performance than a photograph.

The Basic Structure, Top to Bottom

Most income statements follow a similar flow, moving from broader figures at the top to narrower ones at the bottom. Revenue, also called sales, sits at the very top: the total amount earned from selling goods or services, before any costs are subtracted. Below that comes the cost of goods sold, the direct cost of producing whatever was sold, which is subtracted from revenue to get gross profit.

From gross profit, a company subtracts operating expenses like salaries, rent, marketing, and research and development to arrive at operating income. From there, non-operating items like interest expense and taxes are subtracted to arrive at the final figure: net income, commonly called the bottom line, representing what's left for the company after every cost has been accounted for.

A Worked Example

Suppose a small company reports $500,000 in revenue for the year. Its cost of goods sold is $200,000, leaving a gross profit of $300,000 ($500,000 minus $200,000). Operating expenses, including salaries, rent, and marketing, total $180,000, leaving operating income of $120,000 ($300,000 minus $180,000). After $20,000 in interest expense and $25,000 in taxes, net income comes to $75,000 ($120,000 minus $20,000 minus $25,000).

That $75,000 is what the company actually earned for the year after every cost, from producing the product all the way down to taxes, the figure most people mean when they ask whether a company was profitable.

Why Gross Profit and Operating Income Matter Too

Net income gets the most attention, but the intermediate figures tell their own story. Gross profit, and the gross margin percentage that comes from dividing it by revenue, shows how efficiently a company produces what it sells, independent of overhead like marketing or executive salaries. In the example above, gross margin is 60% ($300,000 divided by $500,000), meaning 60 cents of every revenue dollar remains after direct production costs.

Operating income shows profitability from the core business itself, before the effects of financing decisions or tax situations, which can vary a lot between companies for reasons unrelated to how well the underlying business is actually run.

A Word of Caution

An income statement shows profit, not cash in the bank. A company can report positive net income while still running low on cash, because of timing differences between when revenue is recorded and when cash actually arrives, or when expenses are recorded versus paid. That's part of why analysts look at the income statement alongside the balance sheet and the cash flow statement, rather than relying on any single one in isolation.