A lot of things hinge on a company’s profit. Profits determine bonuses, dividends to shareholders, timely repayments to banks and an important measure to attract investors.
To understand an income statement better, let us take a look at the income statement of Innovative Products Inc.
As you can see, the income statement of Innovative Products Inc. shows that the company earned a net profit of $422,500.
There are three key elements of the income statement:
- Revenue – This is earned money, which is not recorded until the customer has received and approved goods. The customer either pays or promises to pay through credit. Earning revenue is not the same as receiving cash. Deposits and advance payments are not revenue.
- Expenses – These are a part of doing business. Some of the money the company makes goes towards producing the company’s product. This can include production costs, advertising costs, and selling costs. You can’t tell how profitable a company is without knowing its expenses.
- Net income – Net income takes into account all the company’s costs, depreciation, interest, taxes, and other expenses and is determined by deducting all expenses from company’s total revenues. The profit amount that takes into account only the direct expenses associated with the goods sold is called gross profit.
Calculating Gross Profits
The income statement provides information that is broken down into several elements. The following elements are used to calculate the company’s gross profit:
- Sales revenue – This is the total amount received or to be received from the sales of products or services to customers. This revenue is net, which means any deductions such as sales, returns, or discounts are already taken out.
- Cost of goods sold expense – This is the total cost of products sold to customers. This may also include the costs of stolen, missing or damaged goods.
To calculate the company’s gross profit, you need to firstly establish the amount of money the company made – sales revenue. Then you examine expenses associated with the cost of goods sold and balance this information against the company’s sales revenue.
Although gross profit doesn’t consider every expense the company faces, it takes into account some basic expenses that directly help companies earn their revenues. This number helps you see, at a high level, how much money the company is making.
Calculating Net Income
Net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. Net income is often referred to as “the bottom line” since net income is listed at the bottom of the income statement.