How to Read & Understand an Income Statement

As a working professional, business owner, entrepreneur, or investor, knowing how to read and analyze data from an income statement—one of the most important financial documents that companies produce—is a critical skill to have.

In addition to helping you determine your company’s current financial health, this understanding can help you predict future opportunities, decide on business strategy, and create meaningful goals for your team.

If you don’t have a background in finance or accounting, it might seem difficult to understand the complex concepts inherent in financial documents. But taking the time to learn about financial statements, such as an income statement, can go far in helping you advance your career.

To help you develop this understanding, here’s an explanation of everything you need to know about income statements—what they are, why they’re important, and how to analyze them—so you can get as much value out of these documents as possible.

What Is an Income Statement?

An income statement is one of the most common, and critical, of the financial statements you’re likely to encounter.

Also known as profit and loss (P&L) statements, income statements summarize all income and expenses over a given period, including the cumulative impact of revenue, gain, expense, and loss transactions. Income statements are often shared as quarterly and annual reports, showing financial trends and comparisons over time.

The Income Statement vs. the Balance Sheet

While the definition of an income statement may remind you of a balance sheet, the two documents are designed for different uses. An income statement tallies income and expenses; a balance sheet, on the other hand, records assets, liabilities, and equity.

Related: Balance Sheets 101: What Goes on a Balance Sheet?

What’s the Purpose of an Income Statement?

The purpose of an income statement is to show a company’s financial performance over a period. It tells the financial story of a business’s activities.

Within an income statement, you’ll find all revenue and expense accounts for a set period. Accountants create income statements using trial balances from any two points in time.

From an income statement and other financial documents, such as the cash flow statement, balance sheet, and annual report, you can determine whether the business is generating a profit; if it’s spending more than it earns; when costs are highest and lowest; how much it’s paying to produce its product; and whether it has the cash to invest back into the business.

Accountants, investors, and business owners regularly review income statements to understand how well a business is doing in relation to its expected performance, and use that understanding to adjust their actions. A business owner whose company misses targets might, for example, pivot strategy to improve in the next quarter. Similarly, an investor might decide to sell an investment to buy into a company that’s meeting or exceeding its goals.

What Goes on an Income Statement?

While all financial data helps paint a picture of a company’s financial health, an income statement is one of the most important documents a company's leadership team and individual investors can review, because it includes a detailed breakdown of income and expenses over the course of a reporting period. This includes:

• Revenue: The amount of money a business takes in during a reporting period
• Expenses: The amount of money a business spends during a reporting period
• Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever it is a business sells
• Gross profit: Total revenue less COGS
• Operating income: Gross profit less operating expenses
• Income before taxes: Operating income less non-operating expenses
• Net income: Income before taxes less taxes
• Earnings per share (EPS): Division of net income by the total number of outstanding shares
• Depreciation: The extent to which assets (for example, aging equipment) have lost value over time
• EBITDA: Earnings before interest, depreciation, taxes, and amortization

These “buckets” may be further divided into individual line items, depending on a company’s policy and the granularity of its income statement. For example, revenue is often split out by product line or company division, while expenses may be broken down into procurement costs, wages, rent, and interest paid on debt.

Income Statement Analysis

There are two methods commonly used to read and analyze an organization’s financial documents: vertical analysis and horizontal analysis. The difference between the two is in the way a statement is read and the comparisons you can make from each type of analysis.

Vertical Analysis

Vertical analysis refers to the method of financial analysis where each line item is listed as a percentage of a base figure within the statement. This means line items on income statements are stated in percentages of gross sales, instead of in exact amounts of money, such as dollars.

In short, it’s the process of reading down a single column of data in a financial statement, determining how individual line items relate to each other (e.g., showing the relative size of different expenses, as line items may be listed as a percentage of operating expenses).

This type of analysis makes it simple to compare financial statements across periods and industries, and between companies, because you can see relative proportions. It also helps you analyze whether performance metrics are improving.

Vertical analysis isn’t always as immediately useful as horizontal analysis, but it can help you determine what questions should be asked, such as: Where did costs rise or fall? What line items are contributing most to profit margins? How are they affected over time?

Horizontal Analysis

Whereas vertical analysis focuses on each line item as a percentage of a base figure within a current period, horizontal analysis reviews and compares changes in the dollar amounts in a company’s financial statements over multiple reporting periods. It’s frequently used in absolute comparisons, but can be used as percentages, too.

Horizontal analysis makes financial data and reporting consistent per generally accepted accounting principles (GAAP). It improves the review of a company’s consistency over time, as well as its growth compared to competitors.

Because of this, horizontal analysis is important to investors and analysts. By conducting a horizontal analysis, you can tell what’s been driving an organization’s financial performance over the years and spot trends and growth patterns, line item by line item. Ultimately, horizontal analysis is used to identify trends over time—comparisons from Q1 to Q2, for example—instead of revealing how individual line items relate to others.

Related: GAAP vs. IFRS: What Are the Key Differences and Which Should You Use?

The Case for Both

The question isn’t whether you should be leveraging vertical or horizontal analysis when evaluating income statements. Instead, it’s: How can you best leverage both forms of analysis to uncover the information you need to make an educated decision? Utilizing both techniques can provide you with more insights than relying solely on one.

Income Statement Example

Here’s an example of an income statement from a fictional company for the year that ended on September 28, 2019.

Go to the alternative version.

This income statement shows that the company brought in a total of $4.358 billion through sales, and it cost approximately $2.738 billion to achieve those sales, for a gross profit of $1.619 billion.

A total of $560 million in selling and operating expenses, and $293 million in general and administrative expenses, were subtracted from that profit, leaving an operating income of $765 million. To this, additional gains were added and losses were subtracted, including $257 million in income tax.

The end result is that the company saw a net income of $483 million for the year.

The Bottom Line

In conjunction with the cash flow statement, balance sheet, and annual report, income statements help company leaders, analysts, and investors understand the full picture of a business’s operational results so they can determine its value and efficiency and, ideally, predict its future trajectory.

Financial analysis of an income statement can reveal that the costs of goods sold are falling, or that sales have been improving, while return on equity is rising. Income statements are also carefully reviewed when a business wants to cut spending or determine strategies for growth.

Learning how to read and understand an income statement can enable you to make more informed decisions about a company, whether it’s your own, your employer, or a potential investment.

Do you want to take your career to the next level? Consider enrolling in Financial Accounting or our other online finance and accounting courses, which can teach you the key financial topics you need to understand business performance and potential. Download our free course flowchart to determine which best aligns with your goals.

Data Tables

Company B Income Statement

For Year Ended September 28, 2019 (In thousands)

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