Financial Statements (iii)

In this article, we will be covering the other important financial statement of a company, called Income Statement.
Balance sheet gives us an idea about the assets and liabilities of a company, as of a specific date. All the items defined in a balance sheet are as of a specific date. On the other hand, items covered in the income statement give details about what has happened over a specific period of time. We will revisit this issue after understanding basics of income statement. Please refer to the below table to understand the basic structure of ABC Inc’s income statement

ItemAmount (in INR)Description
Sales Revenue (a)1,00,000Amount of units sold in a year multiplied by the price per unit (1000*100)
COGS (b)70,000Amount of units sold multiplied by the cost in making each unit (1000*70)
Gross Profit (c=a-b)30,000
SG&A (d)10,000General costs incurred in day to day operations: rent, utilities, insurance etc
EBIT (e=c-d)20,000Earning before Interests and Taxes are paid
Interest (@10%)(f)5,000Interest paid to the bank at the rate of 10% (0.1*50,000)
PBT (g=e-f)15,000Profit before taxes are paid
Tax (@20%) (h)3,000Taxes paid to the government @20% (0.2*PBT)
PAT (i=g-h)12,000Net income generated by ABC Inc in the given financial year
Dividends (j)2,000Dividends distributed to shareholders (friends of Dad)
Retained earnings (k=i-j)10,000Income reinvested in ABC Inc to expand the business

As can be seen in the above table, our starting point is total sales / revenue generated by the company over a specific time period, one full year in ABC Inc.’s case. Various costs incurred by the company during this period are subtracted from the sales number to arrive at profit after tax / net income.

A company can utilize profit after tax in 3 different ways:

1. Entire amount can be distributed to shareholders. In ABC Inc.’s case this would be your dad’s friend and you who are the owners/shareholders of the company.
2. Some part is distributed as dividend and some part is invested back into the company, for research and expansion purpose.
3. Entire profit amount is invested back into the company.

Early stage companies tend to retain most of the earnings as they have enormous potential to grow and capture market share. On the other hand, mature companies who have already grown a lot tend to distribute most of the income to shareholders in the form of dividends, due to lack of growth opportunities.

This clarifies how income statement includes items which give details of what has happened over a specified time period. For example, one cannot declare what is the revenue as of a particular date, because revenue is generated over a period of time. It is important to specify over what period this revenue is generated. On the other hand, one can always specify the amount of assets as of a particular date.

Read our next chapter to understand how to quickly deduce important information from financial statements using key ratios.