The Three Basic Components of Income Statement (Detailed Explanation)

Introduction

It does not matter where you are in the world, where you are based, or where a corporation is incorporated or where headquarters is, wherever a person or a business files an income statement, it needs to show three things everywhere, all over the world, without any exceptions. These three things are also commonly referred to as, ‘The three basic components of income statement.’ The income statement is also sometimes referred to as profit and loss statement or statement of financial performance.

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

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

Furthermore, there are laws and regulations in every country, which makes it mandatory for companies to file an income statement with other statement as mention 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 the company is based in. Lying on an income statement can carry 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 is different from nation to nation, some countries like the United States of America require the companies to disclose a lot of financial information on the income statement, while some countries like Virgin Islands, is not that strict. A detailed analysis is given below:

See also  What is a Budgeted Balance Sheet and How to Prepare It?

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

1) Revenue

Revenue can be defined as the amount of income generated by a business through the sale of goods and services the company sold 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 made from selling the shoes.

The revenue generally does not include any special tax benefits or tax credits or any 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 the reason why revenue sometimes is also referred to as a top line item.

When a company reports it 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 also shows the sales for which it has yet to receive the cash or payment for.

This can create some huge problems if the company does not generate enough cash to continue its operation, even though it is showing huge revenues on its income statement. So, investors must be careful and watch the cash flow statement when investing in a company.

See also  How to Convert from Accrual Basis to Cash Basis of Accounting?

2) Expenses

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

It can be reasonably inferred the more the revenue and less the expensive, the higher the profits, and better the business. In income statement, the expenses are further divided into two categories, which are cost of goods sold and operating expenses.

2.1 Cost of goods sold

It is also known as direct cost due to the fact that it is directly involved in the cost of goods or services which 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 say a law firm, in its income statement, material costs are not included, 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, and 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 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 first two components, liabilities and equity from the value of assets. The calculation is carried out by subtracting revenue from the cost including any capital depreciation, amortization, interest, and tax payment. The net income or profit provides the true picture of the company health.

See also  What is T-Accounting and How Does It Work? (Explanation)

If the revenues are more than the expenses, it means that the company is making a profit or that its net income is positive. But, if the revenues of the company are less than its expenses it means it is going in loss.

Net income is the metric which is used by the investors to evaluate other metrics to calculate the performance of a company. Some of these metrics are profitability ratio, earning per share, and return on assets or equity. So, net income is a very important metric.

3. Conclusion

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 assets, liabilities, and equity. Net income is calculated by taking out liabilities and equity from the value of the assets.

Scroll to Top