The Income Statement: Understanding the financial health of a business - Part 1.

Clayton Ainger
Apr 12, 2023
5 min read

This is the first training blog of two to explain the basics of Income Statement (aka Profit & Loss account). FYI, there is no difference between an income statement and a profit and loss.

1. This blog focuses on the income statement structure, financial terminology, and key financial indicators.

2. The second blog then explains how to understand the financial health of a business through income statement analysis, and cost evaluation, finishing off with how you can help your customers.

Here's why you should read this blog.

Whether you are a sales professional, consultant, business leader, or manager understanding the Income Statement is the starting point to understanding the financial health of a business, setting or measuring budgets, making commercial decisions, risk assessment or implementing change.

If you are in sales, the products, or services you sell should have a positive impact on your customer’s income statement, either through increases in revenue, cost reduction, business efficiency and/or improvement in profitability. Sales excellence means you are able to discuss each of these points with confidence and demonstrate how your product or service brings value to your customers business.

Let’s get into the detail...

What is an Income Statement (IS)

An IS measures the financial performance of a company in a financial year (12 months), or financial period (less than, or more than 12 months). It has three basic parts (see image 1):

1. Revenue.

2. Expenses.

3. Profit or loss.

At the most rudimentary level an IS shows you where a company is spending its money.

Structure of an IS and key financial terms?

Image 2 shows the ‘general’ structure and key financial terms of an IS as organised in the financial statements of your customers. I say general because, different companies will have slightly different categories of expenses, or use different terms for revenue. The more you look at the IS of your customers, the more you will learn to identify the small differences that can take place.

Key financial terms to help build and sharpen your knowledge

Before I begin, if some of these terms are familiar to you, this is a good thing and my question to you is ‘are you using them in your conversations with your customers or executive buyers’, if yes brilliant. If not, why not?

Revenue

Revenue which is sometimes referred to as the ‘top line’ represents expected cash coming in from sales made to customers. Alternative terms for revenue you may come across include – sales, turnover, gross income, operating revenue. It’s important to understand and use the language of your customers business rather than use these general terms.

Expenses

Expenses, in general, represent cash going out, but you will also find non-cash expenses too in the IS.

a. Cash expenses include:

Cost of goods sold (COGS) are direct expenses incurred in the production of a product or delivery of a service to a customer e.g., materials, labour costs.

Selling, general and admin (SGA) are the operating costs of running the business, e.g., heat, light, electricity, telecoms, payroll.

Financing costs e.g., interest expenses

Tax which represents the estimated future tax cost for the business.

b. Non-cash expenses include depreciation, and amortisation.

Depreciation is the write down or decrease in the value of a tangible assets e.g., office equipment, over time.

Amortisation is very similar. It is the write down in the value of an intangible asset e.g., a licence, over time.

Gross Profit, (or Gross Margin in US)

GP is the difference between a company’s total revenue and its total cost of goods sold. It reveals the amount a business earns from selling is products or services, before deducting the costs of running the business.

The GP on an individual product is the selling price of your product minus the cost of producing it. For a service business, it is the selling price of your service, less the time spent on doing the job.

Operating profit (or Net Operating Income in US)

OP indicates the ability of a company to generate cash from its operations. Alternative terms for operating profit include:

EBIT – Earnings Before Interest and Tax (NB: this is not EBITDA)
PBIT – Profit Before Interest and Tax

EBITDA (pronounced ‘ee-bit-dah’)

EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation. EBITDA is one of the most widely used measures of a company’s financial health and ability to generate cash, but interestingly, it is not normally included in an IS because it is not yet recognised as measure of financial performance under normal accounting rules.

EBITDA has two important meanings, firstly, it is the purest indication of profit because it is before depreciation and amortisation, which can distort profit as different companies use different depreciation / amortisations policies preventing comparison of operating profit across similar businesses, and secondly it gives a quick snapshot in time of available cashflow being generated by a company.

NB: Despite not being included in an IS, EBITDA is relatively easy to calculate using either of the two formulas:

a. Operating Profit (EBIT) + depreciation + amortisation.

b. Net Profit + interest + tax + depreciation + amortisation

Net Profit or Profit for the year (or Net Income in US)

NP which is sometimes referred to as the ‘bottom line’ because it falls at the bottom of the IS, tells a company how profitable it was as a whole during a financial year or financial period.

Key financial indicators

The following are used as key financial indicators when analysing an IS and we will look at how to use these indicators to assess financial health and financial performance in our next blog:

Gross profit
EBITDA
Operating profit (aka EBIT)
Net Profit (aka Profit for the Year)

EXERCISE - It’s now time to practice and play...

Download the financial statements for your top five favourite customers, whose businesses you are familiar with. Then compare the income statements of each customer. Notice what you notice...

For now, locate and familiarise yourself with the key terms used in each business for the following:

Revenue, sales, turnover, gross income
Gross profit (or gross margin if a US customer)
Operating profit / EBIT (or net operating income if a US customer)
Expenses – cost of goods sold, selling, general, admin.
Net profit / Profit for the year (or net income if a US customer)

If you fancy a challenge, have a go at calculating EBITDA by using either of the two formulas:

a. Operating Profit (EBIT) + depreciation + amortisation.

b. Net Profit + interest + tax + depreciation + amortisation

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