A traditional income statement is key to learning more about a company and how well it is performing.
A business’ income statements are valuable for a few reasons. Investors need to know what’s on an income statement so that they can tell if the company’s stock is worth buying. Company executives turn to these financial reports to help them identify ways to improve the company so it can grow competitively. And lenders or creditors may want to see income statement information before making decisions on financing.
A traditional income statement, also known as a profit and loss (P&L) statement, provides a snapshot of a company’s ability to make money. It includes several key metrics that help you better understand how the firm’s profit and loss relate to each other.
What Items Appear on an Income Statement?
Key items on a traditional income statement include:
Revenue or sales is the amount of money a company brings in as a result of selling its products or services.
Expenses are what it costs to produce a product or service.
Gains are the profits, which is the money the company takes in after subtracting all expenses.
If the company has no gains because its costs are greater than its revenue, than it is suffering losses. It is the negative amount after subtracting expenses that are greater than revenue or sales.
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The Difference Between a Contribution Margin Income Statement and a Traditional Income Statement
With a traditional income statement, the format is straightforward. It focuses on gross profit as the total sales minus the cost of goods sold by separating product costs and period costs.
- Product costs: Companies incur product costs to manufacture their product such as for labor, overhead or materials. Both variable and fixed costs can be included in the cost of manufacturing.
- Period Costs: Companies incur period costs when they sell their products such as for marketing and sales commissions.
A contribution income statement, on the other hand, shows similar information, but it separates variable costs from fixed costs. To get the contribution margin, the variable costs are subtracted from the revenue. This way, you can see how revenue is contributing to fixed costs and income as you calculate the gross profit.
This offers a different perspective on the driving forces behind a company’s income trends, revealing a bit more detail about the costs for making the product or providing the service.
- Fixed Costs: Fixed costs are constant costs. They do not change as a company makes or sells more product. For example, insurance, leases and interest payments remain the same, not matter how much business the company does.
- Variable Costs: Variable costs change as the company’s output changes. They include labor, commission and materials costs. If a company makes and sells more product, its variable costs increase. If it makes and sells less, its variable costs decrease.
In calculating the “cost of goods sold” on a traditional income statement, both variable and fixed costs are included. This is not the case with the contribution margin approach, which subtracts variable selling costs and variable product costs and not fixed manufacturing costs.
Generally, a company presents a traditional income statement to people outside the company. It prepares a contribution income statement to share with managers and investors with a significant take in the company.
How Investors Scan What’s on an Income Statement
The information on a traditional income statement is important to investors. It reveals a company’s profitability trends by comparing the current profitability to past profitability figures. You can see quickly whether a company has made a profit or a loss during a particular accounting period, usually quarterly or annually.
Investors can scan an income statement for key financial points like revenue and costs/expenses, so they can get a sense of how the company is performing. They can see at a glance, for examples, whether the company’s profitability is driven by increasing sales, decreasing costs or both.
Or, they may identify areas of weakness such as sliding revenue or increasing costs that can affect profitability.
Investors use core financial reports like traditional income statements to analyze a potential investment. They review profitability trends that can provide clues for how well the company may perform in the long-run. Information on income statements can be compared to the company’s past income statements, as well as to its competitors.
Other Key Financial Statements
The traditional income statement is one of three main types of financial statements that illustrate a company’s performance. Investors also turn to a company’s balance sheet and cash flow statements for other detailed financial information.
- Balance Sheet: A core financial report details a company financial situation at a given moment in time, like a snapshot of its financial health. It includes assets, liabilities and shareholder equity.
- Cash Flow: A core financial report that details how a company makes its money. The three main types of cash flow statements are financing, operating and investing.
How Small Businesses Can Prepare an Income Statement
Small business owners have many reasons for wanting to prepare an income statement. Although small businesses are not required to file an income statement with the Securities and Exchange Commission (SEC) the way larger publicly traded companies are, they can gain valuable insight into their business with an income statement.
Small businesses can turn to a professional accountant or one of several online templates to guide them through the process of how to prepare an income statement. For example, you can find traditional income statement templates online with Office Depot for free.
Or, small businesses with simple income figures can build their own income statement by taking these steps in building their own template
The Bottom Line
Investors are highly interested in income statements as core financial statements that hold valuable information about a company’s financial health. A profit and loss statement can help investors make decisions about what to include in their portfolio or their client’s portfolio.
For company executives, the value of income statements is that can shed light on what changes they may need to make to keep the company growing competitively. They can identify areas of weakness and strengths, both compared to the company’s past performance and to its peers.