The balance sheet is a snapshot. The income statement is a movie. It covers a stretch of time, usually a quarter or a year, and answers one question: did the business make money over that period? This is Part 1 of our Read the Numbers series, and it picks up the same hypothetical wholesale distributor we used in How to Read a Balance Sheet in Five Minutes.
The SEC's own Beginners' Guide to Financial Statements describes an income statement as a report showing how much revenue a company earned over a specific period, along with the costs and expenses of earning it. It reads from the top down like a staircase: start with sales, subtract costs at each step, and end at the "bottom line," which is net profit or net loss.
The staircase, one step at a time
- Revenue (sales). Everything the company billed customers for the period, after returns and allowances. It's the top line.
- Cost of goods sold (COGS). The direct cost of the products sold: what the distributor paid for the inventory it shipped out. Subtract it from revenue and you get gross profit.
- Operating expenses. The costs of running the business that aren't tied to a specific product: salaries, rent, marketing, and depreciation, which spreads the cost of equipment over its useful life. Subtract these from gross profit and you get operating income.
- Interest and taxes. Operating income is before financing costs and taxes. Subtract interest on debt and income taxes, and what's left is net income.
| Line | Amount | % of revenue |
|---|---|---|
| Revenue | $1,200,000 | 100.0% |
| Cost of goods sold | ($720,000) | 60.0% |
| Gross profit | $480,000 | 40.0% |
| Selling, general & administrative | ($300,000) | 25.0% |
| Depreciation | ($40,000) | 3.3% |
| Operating income | $140,000 | 11.7% |
| Interest expense | ($12,000) | 1.0% |
| Pre-tax income | $128,000 | 10.7% |
| Income taxes (25% assumed) | ($32,000) | 2.7% |
| Net income | $96,000 | 8.0% |
The right-hand column is the useful one. Dividing every line by revenue turns a pile of dollar amounts into percentages you can compare against last year, against a competitor, or against a company ten times the size.
Three margins that tell the story
- Gross margin shows whether the company can sell its product for meaningfully more than it costs. A shrinking gross margin often means rising input costs or price cuts.
- Operating margin shows how much of each sales dollar survives after running the business, before financing and taxes. It's often the cleanest read on how good the underlying operation is.
- Net margin is the final cut after interest and taxes.
Why growth in revenue isn't the whole story
Headlines love revenue growth, but revenue is only the first step on the staircase. Here's what happens if the example company grows sales 10% but its product costs creep up from 60% to 63% of revenue:
This is why the income statement is read in the percentages and across several periods, not just in the headline number.
Earnings per share, in one paragraph
For a public company, the income statement also reports earnings per share (EPS). The SEC guide explains it as how much money shareholders would receive for each share they own if the company distributed all of its net income. It's net income divided by the number of shares, which makes profit comparable across companies of different sizes, and also makes it sensitive to share buybacks and new share issuance. Our example is a private business with no public shares, so there's no EPS line.
What the income statement can't tell you
- Whether the profit arrived as cash. Revenue is recorded when it's earned, not necessarily when customers pay. A profitable company can still be short of cash. That's the subject of Part 2: How to Read a Cash Flow Statement.
- What it owns and owes. That's the balance sheet.
- Which numbers are one-time. Companies sometimes highlight an "adjusted" profit that leaves out costs they call unusual. We cover how to read those in Part 5.
Where to find one
Every public U.S. company files an income statement in its annual report (Form 10-K) and, unaudited, in each quarterly report (Form 10-Q). Both are free on the SEC's EDGAR database, as covered in Part 4. Some filings call it a "statement of operations" or "statement of income"; it's the same thing.
Common questions
What's the difference between gross profit and net income?
Gross profit is revenue minus only the direct cost of the product sold. Net income is what remains after every other expense, including operating costs, interest, and taxes, has been subtracted. Gross profit is the first rung of the staircase; net income is the last.
What is a good profit margin?
It depends on the industry. Businesses that sell physical goods in competitive markets often run thin margins, while software and licensing businesses run higher ones. The most useful comparison is a company against its own past results and its closest competitors.
Does net income mean the company has that much cash?
No. Net income is an accounting measure that includes non-cash items like depreciation and counts sales before they're collected. The cash flow statement shows what actually happened to the cash.
- U.S. Securities and Exchange Commission, Beginners' Guide to Financial Statements
- SEC, EDGAR company filing search