The Three Basic Components of Income Statement (Detailed Explanation)

The income statement is also sometimes referred to as a profit and loss statement or statement of financial performance.

The three basic components of an income statement are revenues, expenses, and, net income. It is a must for public companies listed on a stock exchange to file the income statement along with another statement such as a balance sheet, statement of change in equity, statement of cash flow, and noted financial statements.

It allows the investors to evaluate the health and performance of a business or a company and helps them judge whether or not to invest in the company.

Furthermore, every country has laws and regulations, which make it mandatory for companies to file an income statement with other statements as mentioned above.

It can be an annual or a quarterly income statement, or both, depending on the laws of the company and the legal requirements of the Country in which the company is based.

Lying on an income statement can carry a severe penalty, ranging from financial fines, jail time for the people involved, or an outright ban.

The details regarding what to declare in an income statement differ from nation to nation, some countries like the United States of America requires companies to disclose a lot of financial information on the income statement, while some countries like the Virgin Islands, are not that strict.

A detailed analysis is given below:

Basic Components

The three basic components of an income statement are shown in figure 1 below:

Figure 1: The three basic components of an income statement

The three basic components of an income statement as shown in figure 1 are revenue, expenses, and net income.

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These are further divided into multiple components depending on how a business files an income statement. All the details of each component and sub-components are given below:

1) Revenue

Revenue is the income a business generates through the sale of goods and services the company sells to its customers.

This includes the main part of the business. For example, if a company sells shoes, the revenue of the company will show the amount of money it makes from selling them.

The revenue generally does not include any special tax benefits or tax credits or depreciation. It means the revenue only shows how much money the company made by selling its main product or service.

When a company files an income statement, it always shows revenue at the top of the income statement. That is why revenue is sometimes referred to as a top-line item.

When a company reports its revenue, it is based on the price of goods or services sold, which means, the revenue does not cover the cash flow.

It also means that when a company reports revenue, it shows the sales for which it has yet to receive the cash or payment.

This can create huge problems if the company does not generate enough cash to continue its operation, even though it shows huge revenues on its income statement.

So, investors must be careful and watch the cash flow statement when investing in a company.

2) Expenses

Expenses can be called the cost of doing business. It covers everything which is costing the company money to generate revenue. The expenses come after the revenue in the income statement of a business.

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It can be reasonably inferred the more the revenue and less expensive, the higher the profits, and the better the business.

The income statement further divides the expenses into two categories: the cost of goods sold and operating expenses.

2.1 Cost of goods sold

It is also known as direct cost because it is directly involved in the cost of goods or services a company sells. The three main divisions in the cost of goods sold are labor costs, materials costs, and overhead costs.

These three costs are generally highlighted in the income statement for a company that manufactures things.

For a service company, like a law firm, material costs are not included in its income statement because they are not converting one material into another, like a manufacturing company.

2.2 Operating expenses

The operating expenses cover every expense related to the operations of a company. Now, the operating expenses can be employee salaries, utilities and rent costs, capital depreciation, marketing costs, and so on.

The operating expenses can be further divided into administrating and selling expenses.

Administrative expenses are related to the administration costs, whereas selling expenses are related to the direct cost of selling such as salesmen.

3) Net Income

Net income is also commonly known as net profits. The net income is the last entry in the income statement.

The net income is calculated by subtracting the value of the first two components, liabilities and equity from the value of assets.

The calculation is carried out by subtracting revenue from the cost, including capital depreciation, amortization, interest, and tax payment. The net income or profit provides the true picture of the company’s health.

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If the revenues are more than the expenses, the company is making a profit or its net income is positive. But, if the company’s revenues are less than its expenses, it is going into a loss.

Net income is the metric that investors use to evaluate other metrics to calculate the performance of a company.

These metrics are profitability ratio, earnings per share, and return on assets or equity. So, net income is a very important metric.

3. Conclusion

An income statement is a very handy tool that can help an investor evaluate a company’s performance.

It has all the important metrics listed in it, which helps the investor create performance criteria for the company.  

The three main components of an income statement are revenue, expenses, and net income. Net income is calculated by taking out expenses from the total revenue.