Income Statement Analysis: How to Read an Income Statement

A balance sheet and an income statement are two different methods of gauging a business’s financial health. In this article, we’ll define a balance sheet and income statement, explain what goes on each document, and review their differences. The income statement shows you how profitable your business is over a given time period. And the balance sheet gives you a snapshot of your assets and liabilities.

What Is Included in the Balance Sheet?

The balance sheet is typically prepared monthly, quarterly, or annually. You could prepare one whenever you need to show your company’s financial position. One side shows the company’s short- and long-term assets and the other side shows its liabilities and equities for a specific point in time.

1. We will also discuss how decision-makers at various levels use this information to help pursue their financial goals.
2. The balance sheet shows your company’s assets, liabilities, and equity – basically the financial health of the business at a specific point in time.
3. The income statement provides information about a company’s sales revenue, expenses, gains and losses.
4. The balance sheet can tell you where a company stands financially, and is separated into three main sections — assets, liabilities, and equity.

Revenue and Gains

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How to Read & Understand an Income Statement

By reviewing a company’s income statement, you can quickly pinpoint areas that have room for improvement. For example, a company could cut costs in one area and put more money into others, such as sales and marketing, that could potentially fuel expansion. Other costs that would be counted under expenses would be operating and non-operating expenses.

Income statements: Conclusion

Income statements are also carefully reviewed when a business wants to cut spending or determine strategies for growth. Vertical analysis refers to the method of financial analysis where each line item is listed as a percentage of a base figure within the statement. This means line items on income statements are stated in percentages of gross sales, instead of in exact amounts of money, such as dollars. Accountants, investors, and business owners regularly review income statements to understand how well a business is doing in relation to its expected future performance, and use that understanding to adjust their actions.

After preparing the skeleton of an income statement as such, it can then be integrated into a proper financial model to forecast future performance. After deducting all the above expenses, we finally arrive at the first subtotal on the income statement, Operating Income (also known as EBIT or Earnings Before Interest and Taxes). The total tax expense can consist of both current taxes and future taxes. Are you interested in gaining a toolkit for making smarter financial decisions and communicating decisions to key stakeholders? Explore our online finance and accounting courses, and download our free course flowchart to determine which best aligns with your goals.

Shareholder’s equity also includes retained earnings ― the portion of the net income that hasn’t been distributed to shareholders as dividends ― to be used for funding further growth and expansion of the business. This segment of the balance sheet includes return of equity (ROE), calculated by dividing net income by shareholder’s equity. ROE measures management’s effectiveness in employing and driving returns based on equity.

Unlike the income statement, it does not provide information on how much money the company has made or lost, it only provides the amount of debt, cash and other assets that the company owns at that point in time. A balance sheet represents a company’s financial position for one day at its fiscal year end, for example, the last day of its accounting period, which can differ from our more familiar calendar year. Companies typically select an ending period that corresponds to a time when their business activities have reached the lowest point in their annual cycle, which is referred to as their natural business year. Financial analysis of an income statement can reveal that the costs of goods sold are falling, or that sales have been improving, while return on equity is rising.

Beyond the editorial, an annual report summarizes financial data and includes a company’s income statement, balance sheet, and cash flow statement. It also provides industry insights, management’s discussion finance concierge for startups and analysis (MD&A), accounting policies, and additional investor information. As mentioned earlier, the financial statements are linked by certain elements and thus must be prepared in a certain order.

Our platform features short, highly produced videos of HBS faculty and guest business experts, interactive graphs and exercises, cold calls to keep you engaged, and opportunities to contribute to a vibrant online community. The modest outlay could save you boatloads of cash at tax time, not to mention save you from pulling out all your hair trying to balance your books. Some liabilities are considered off the balance sheet, meaning they do not appear on the balance sheet. Third, the financing section shows changes in a company’s debt, loans, or dividends. For example, when a company receives cash as a result from issuing debt, this adds to the cash coming in.

Imagine if your balance sheet is produced right after you pay off a substantial debt and before you deliver a sizable order to a customer. Your cash position is only temporarily low, but you can’t always explain that in the balance sheet. Investors and lenders use it to determine creditworthiness and availability of assets for collateral. After enrolling in a program, you may request a withdrawal with refund (minus a $100 nonrefundable enrollment fee) up until 24 hours after the start of your program. Please review the Program Policies page for more details on refunds and deferrals. We expect to offer our courses in additional languages in the future but, at this time, HBS Online can only be provided in English.

Accountants create income statements using trial balances from any two points in time. Whether you plan on managing your books on your own or plan on hiring an accountant, it is critical to understand how your income statements and balance sheet affect one another. Every time your business makes a financial transaction, it is possible that both your present balance sheet and future income statement can change. Clearly, both the balance sheet and the income statement—along with other financial statements, such as the statement of cash flow—can be very useful. However, to know whether you should use a balance sheet vs income statement, it is important to identify the structural differences between the two.

Investors and analysts keep a close eye on the operating section of the income statement to gauge management’s performance. The P&L statement is one of three key financial statements a business releases, either quarterly, annually or both if it’s a public company. It keeps track of profitability, income sources, expenses and budgets, allowing the company to take action against variances from projections.

Companies produce three major financial statements that reflect their business activities and profitability for each accounting period. These statements are the balance sheet, income statement, and statement of cash flows. The cash flow statement shows how well a company manages cash to fund operations and any expansion efforts. In this article, we’ll examine the balance sheet and income statement and their differences. An income statement is one of the three important financial statements used for reporting a company’s financial performance over a specific accounting period. The other two key statements are the balance sheet and the cash flow statement.