How to Prepare an Income Statement

What is an income statement?

The income statement, sometimes also referred to as the profit and loss statement (P&L), tracks how profitable a company is over a period of time. The statement tracks profitability by looking at the revenue generated by the business and subtracting out expenses to arrive at net income or net earnings.

Simply put, the guideline equation is Revenue - Expenses = Net Income

The income statement is designed to start with revenue, then deduct expenses until you are left with net income (income after all expenses).

Key Income Statement Line Items

There are several key income statement line items that represent different stages in the income statement where certain expenses have been accounted for while other expenses have yet to be accounted for.

Key income statement items you should look for:

1. Gross Profit
2. Operating Income (EBIT)
3. Pretax Income (EBT)
4. Net Income

To prepare a full income statement, simply follow the below steps to piece together the 4 key line items that will take your from total revenue all the way down to net income!

#1 Gross Profit

Let’s start with gross profit. The gross profit line comes near the very top of the income statement and can be represented by the simple formula: Revenue - Cost of Goods Sold = Gross Profit

Revenue

Revenue, also known as sales, represents the money a business receives from its customers for selling a product or providing a service. 

Different industries and business will have different pricing and business models, but most can be boiled down to a simple formula: Price * Quantity Sold = Revenue.

You should also note that sometimes larger, complex businesses will split their revenue into subcategories on their income statement. For example, Apple will often split their revenue into product revenue and service revenue.

Cost of Goods Sold (COGS)

The cost of goods sold, often referred to as COGS, represents the direct cost associated with selling the company’s product or service.

Example expenses that would be grouped into cogs:

• Raw materials
• Packaging
• Shipping

Once you have your revenue and COGS, you can simply subtract COGS from revenue to arrive at gross profit. Although there are still many more expenses to be accounted for later on in the income statement, gross profit is often seen as a good first look into a company’s profitability.

If gross profit is too low, a business could look into 2 improvement options

• Boost revenue by raising prices and/or selling more units.
• Decrease COGS expense by optimizing materials, labor, etc.

#2 Operating Income (EBIT)

Now let’s move further down the income statement to find operating income. The operating income formula is also pretty simple: Gross Profit - Operating Expense = Operating Income.

Operating Expenses

Operating expenses cover all expenses that are related to the core operations of a business. You’ll notice that expenses like taxes and interest expenses are not included in this section since those expenses don’t keep the business up and running.

Typical Operating Expense Line Items:

• Selling, General, Administrative (SG&A): SG&A can be thought of as indirect costs that are related to the core operations of the business. These expenses cover rent, salaries, insurance, etc.
• Research & Development (R&D): Most larger companies will have research and development costs used to test and experiment new products and services.
• Other Operating Expenses: Some companies (not all) will have this line item and it basically catches all other operating expenses not bucketed into SG&A or R&D.

Financial analysts like looking at operating income because it shows how profitable a business is when only accounting for COGS and operating expenses which are both linked to the core operations of the business. 

Since operating income doesn’t yet account for interest expense and taxes (expenses that show up later down the income statement), this line item is also referred to as EBIT which stands for Earnings Before Interest and Taxes.

#3 Pretax Income (EBT)

Next we have pretax income which is also known as a business’ taxable income. Before coming to taxable income, business’ are allowed to deduct interest expense to lower their taxable income. Again, the formula here is very simple: Operating income - interest expense = pretax income

Interest Expense

If a business took out a loan from a bank or issued bonds to debt investors, they would usually be charged some sort of interest for borrowing money. This interest expense is then deducted on the income statement so that a business can lower its taxable income (pretax income).

#4 Net Income

Finally, we have net income, also sometimes known as net earnings or the bottom line. Net income represents what the business gets to keep after deducting all expenses. The formula here is Pretax Income - Taxes = Net Income.

Taxes

Taxation policy and tax reduction strategies can get really complex as you’ll have to take into account changes in tax regulation, industry specifics, etc. As a general rule of thumb, most developed countries will have a corporate tax rate of around 20-30%.

If you were to make a simple assumption and ignore the complexities of tax law, you would multiply the corporate tax rate by a company’s pretax income to calculate how much it has to pay in taxes.

Real Income Statement

Publicly traded companies like Apple Inc. are required to file and release income statements every year through the SEC 10-K form. Below is an example of Apple's real 2021 income statement (also known as a consolidated statement of operations).

When reading real company income statements, you'll notice that companies will sometimes use different naming conventions and include unique line items that can be specific to the industry or business.

If you would like to learn more about how to read, analyze, and create financial models using real company income statements, check out our Complete Finance & Valuation Course.

Additional Resources

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