An income statement (also called a profit and loss account) shows a firm’s revenues and expenses over a period of time, usually a year. It reveals whether a business has made a profit or loss and how that result was achieved.
Structure of an income statement
The main components are:
- Revenue (sales turnover) – the value of goods or services sold.
- Cost of sales – the direct costs of producing the goods sold (materials, direct labour). Subtracting cost of sales from revenue gives gross profit.
- Operating expenses – overheads such as administration, selling and distribution costs. Deducting operating expenses from gross profit gives profit from operations (operating profit).
- Non‑operating items – interest received, interest paid and exceptional items. Subtracting these from operating profit gives profit for the year.
For limited companies, the profit for the year is appropriated between dividends to shareholders and retained earnings kept in the business.
Why income statements are useful
They enable owners, managers and investors to assess performance, identify trends, control costs and plan for the future. Banks and other lenders use them to decide whether to lend, and governments use them to assess tax liabilities. Stakeholders compare a company’s income statement with previous years and with competitors to evaluate profitability.
It is important to understand that an income statement is backward‑looking – it records past performance. It also relies on accounting policies (e.g. how depreciation is calculated) that can affect reported profit.
| Item | Amount ($) | Explanation |
|---|---|---|
| Revenue | 100,000 | Total sales for the year. |
| Cost of sales | 60,000 | Direct costs (materials and direct labour). |
| Gross profit | 40,000 | Revenue – cost of sales. |
| Operating expenses | 20,000 | Indirect costs (rent, marketing, administration). |
| Profit from operations | 20,000 | Gross profit – operating expenses. |
| Interest expense | 2,000 | Interest on loans. |
| Profit for the year | 18,000 | Profit from operations – interest. |
Examples and applications
Small businesses use income statements to understand where their money comes from and where it goes. A freelance graphic designer might invoice clients $50,000 over a year. Their cost of sales includes software subscriptions and printing costs of $10,000, leaving a gross profit of $40,000. Operating expenses such as office rent, internet, advertising and insurance might total $15,000, leaving profit from operations of $25,000. After paying $1,000 in interest on a business loan, the designer earns $24,000 profit for the year.
Analysing an income statement helps the designer identify which expenses could be reduced (e.g. switching to cheaper software) and whether to raise prices or seek more clients to increase revenue. Investors and banks use similar statements to assess whether a business is profitable and capable of repaying loans.
