A company's financial statements are its performance scorecard. Taken together, they show the financial health of company and provide clues as to its future prospects. The income statement, balance sheet and cash flow statement are primary financial statements of a company, but the income statement details whether the company made or lost money in any given period. For this reason, it receives a lot of attention from business owners, investors and lenders.
The income statement, sometimes referred to as a profit and loss statement, provides details about how much a company earned or lost. The dollar amount of sales or revenue for the period is the number from which all operating costs are deducted. For many companies, the cost of goods sold, which usually appears underneath sales, is the single largest operating expense. Cost of goods sold represents the cost of raw materials used in producing the goods, and direct labor costs. Other items listed on the income statement include general and administrative expenses, rent, operating lease payments, depreciation, and utilities. The income statement subtracts theses expenses and taxes to arrive at a net income or loss amount. Net income is sometimes referred to as "the bottom line," as it is usually appears as the last line of the income statement.
Business managers, lenders and investors place a high importance on profit margin, which shows how much money a company keeps after taking into account all of its expenses. Gross margin and profit margin -- sometimes referred to as net margin -- are closely followed. Gross margin is sales less cost of goods sold divided by sales. For example, if a company had sales of $1 million, and cost of goods sold was $650,000, its gross margin is 35 percent, derived by subtracting $650,000 from $1 million and dividing the result by $1 million. This means that for every $1 of sales, the company gets to keep $0.35 after accounting for cost of goods sold. Profit margin is net income divided by sales. If the same company earned $110,000 in net income, this means its profit margin is 11 percent, which is $110,000 divided by $1 million.
Gross margin and profit margin receive a lot of attention, but there are other profitability ratios that utilize some components of the income statement and other financial statements to determine a company's profitability. Return on assets measures a company's ability to convert its assets into profit. The calculation for return on assets is net income plus after-tax interest expense divided by average total assets from the balance sheet. Return on equity measures the company's return on its investment to shareholders. To calculate return on equity, divide net income by average shareholder's equity. The higher the return on equity, the better.
Looking at a company's income statement for one period in isolation doesn't really give a true picture of how things are going. It is common practice to compare the income statement over various periods, such as year-over-year or quarter-over-quarter, to identify trends. This also allows management to make future projections about income and growth. For instance, if sales have steadily increased by 10 percent over the previous 5 years, it is reasonable for the company to project 10-percent sales growth for the upcoming period, unless it believes there are circumstances that require an adjustment to its sales forecast upward or downward. In addition, projections about expenses and other line items allow a company to make a forecast for net income.
