What is an income statement?

The income statement is one of the three financial statements investors must understand in order to analyze businesses.

The purpose of the income statement is to show whether a company is profitable, by showing its operating results over a period of time.

You can think of the income statement as your household budget.

If you were to look at your monthly budget, you would start by showing how much money you make from your job or other sources. Then, you'd subtract the expenses that you accrue during the month. The result? Your savings rate. With a company, the income statement follows a similar model.

Notably, the income statement uses accrual accounting. This means revenue & expenses are recorded when a transaction occurs, regardless of whether a payment has been made.

The most important figures on the income statement

The income statement provides three crucial figures for investors:

1. Revenue: Total sales
2. Expenditures: Total costs and expenses
3. Income: How much profit was generated

A company's revenue, or sales, is all the money it makes by selling its products and services.

The company's expenditures, such as supplier costs and employee salaries, are subtracted.

The result is a company's profit (if a surplus amount is left over) or loss (if its expenses exceed its sales).

The income statement has a beginning and end date and usually measures a company's quarter or year.

This graphic shows a typical layout for income statements, but individual companies might use variations.

Going through the income statement line by line

Revenue – A company's total sales after accounting for all discounts, rebates, and other paybacks.

For instance, if Domino's Pizza sells a large pepperoni pizza for $12 but runs a 50% off special for the NFL opening weekend, it only records $6 of revenue for each pepperoni pizza it sells during that special.

Cost of Goods Sold (COGS) – This is subtracted from revenue and includes all expenses a company accrues to make its product or deliver its service. These include raw materials, paying suppliers, employee costs, and equipment depreciation.

For our Domino's Pizza example, COGS would include dough, cheese, and sauce costs.

Gross Profit – This is the result of subtracting COGS from revenue. Simply put, it is the total profits before operating expenses. This is one of the most critical numbers on the income statement.

Operating Expenses – We subtract a company's various operating expenses after gross profit.

Operating expenses include everything a company spends on "overhead." These expenses are often lumped together into common categories like sales and marketing (S&M), research and development (R&D), and selling, general, and administrative expenses (SG&A).

For our Domino's Pizza example, operating expenses include spending on TV commercials and its corporate kitchen to develop new pizza recipes.

Operating Income – After subtracting operating expenses from gross profit, operating income is the result. This is the surplus that a company earns from running the business. It is another important number for investors to know.

Non-Operating Income/Expenses – This line item can include all the ways a company can earn and spend money not related to its core business.

On the income side, it could include interest it earns from cash it holds in its bank account.

On the expense side, it can include the interest it must pay on its debts.

Pre-Tax Income – Sometimes referred to as EBT (earnings before taxes), this is the company's earnings before paying taxes.

Tax - Includes all the federal, state, and local taxes a company must pay.

Net Income – This represents a company's total net income (also called "earnings" or "profits") during the period. However, public companies have one more step before reaching the ultimate bottom line.

Shares Outstanding – This is the total number of shares a company has. Each share has an equal claim on a company's earnings.

Earnings Per Share (EPS) – Finally, we determine how much earnings each share has a claim on by dividing net income by outstanding shares.

In your search for great investments, the income statement can provide many clues beyond whether a company is profitable. It reveals whether a company uses a lot of debt to fuel growth or needs to spend a lot of money on R&D to maintain its competitive advantage.

Understanding these key terms and how each was reached will help you become a better investor.