Income Statement

While the balance sheet gives an exhaustive description of a company's resources and obligations, it does not indicate whether the company is making or losing money. This is the function of the income statement. The income statement (sometimes called the profit and loss statement) shows how much money the company has made or lost over a specific period of time such as a fiscal year. It is a report about the performance of the business and on its ability to generate a profit [just as the balance sheet is a report on the status of the owners' investment in a company].

The period covered by an income statement is typically either a quarter, or as in the example below one fiscal year. As a rule an income statement includes of the following major elements:

• Gross sales
  
• Net sales
  
• The cost of goods sold
  
• Gross profit
  
• Operating expenses
  
• Operating profit
  
• Certain adjustment to operating profits
  
• Pretax profits
  
• Taxes payable, and
  
• Net income after tax
  

The company's net sales for the reporting period is calculated by subtracting discounts, returns, and allowances for bad debts from gross sales (which are shipments at invoice price).

The cost of goods sold during the reporting period is determined in two steps: First, the value of inventory on hand at the beginning is added to the cost of raw materials, manufacturing labor, and factory overhead to determine the cost of inventory available for use. Second, the value of the inventory on hand at the end of the period is subtracted from this figure to provide the cost of goods sold. Gross profit is the figure that remains after the cost of goods sold is subtracted from net sales.

Total operating expenses [sometimes referred to as selling, general and administrative expenses or S,G & A] are determined by adding all costs incurred in selling and distributing the company's products, as well as other costs associated with administering the business such as salaries or compensation for workers at the company headquarters.

Notice that executive salaries are listed as a separate item in the attached example. This is desirable, particularly in small and medium-sized companies, to show that executive compensation is not excessive in relation to company's overall financial performance. However, listing executive compensation in this manner is not commonly done. A company's operating profit is determined by deducting total operating expenses from gross profit.

Income derived from sources other than sales is added to operating profit, and extraordinary expenses unrelated to the company's normal operations are subtracted from operating income to calculate a company's net income before income taxes. Income taxes are then subtracted from this figure to calculate the company's net profit or net loss after tax for a year.

A net profit is theoretically the amount available for reinvestment in the business for the payment of dividends or for reinvestment, but credit managers should realize that profit and cash on hand are not the same thing. A company can show a substantial profit over an accounting period and have little or no cash on hand at the end of the accounting period for either dividend payments or reinvestment.

Although income statement figures can be valuable aids in judging a credit risk, privately held companies are sometimes more reluctant to share income statements or exerpts from income statements with creditors. Generally, privately held companies are more likely to share balance sheet information only.

Banks, which are typically secured creditors, always ask commercial borrowers to periodically submit complete financial statements including income statements, balance sheets, and cash flow statements. Credit reporting agencies also ask for income statements as well as balance sheets from the companies they interview, and trade creditors should always request this information since it is not unprecedented or improper to do so.

In an effort to make it easier for small companies that do not regularly prepare financial statements to report relevant information to creditors, some creditors send financial statement forms to credit applicants. These forms provide spaces to complete income and expense breakdown, as well as for sales figures. These forms also include blanks in which the applicant is asked to list data from its balance sheet.

Most credit professionals agree that both the balance sheet and income statement are essential to a thorough analysis of a customer or applicant's financial condition. In order to determine whether a company's financial performance is improving or weakening, it is essential to have two or more accounting periods of data to compare. Making a side-by-side comparison of a company's income statement and balance sheet over two or more accounting periods makes determining trends and spotting emerging problems far easier than looking at a customer's financial performance during a single accounting period.

Source: Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore.