How to Understand an Income Statement
Question
What expenses comprise the differences between the terms "total revenue", "operating income", "earnings", and "net income"?Answer
The easiest way to explain that is to walk through an Income Statement with you. Let's use a really simple fictitious statement as the one shown below. Even though accounting is far more science than accounting, there are many terms for the same items and it can be confusing. For several of the main categories, I've shown in brackets and italics some alternate terms.
Revenue - While the most common term to describe the amount of sales a company recognizes in the given period is "Revenue", it is sometimes called Sales. Unfortunately is it called "Income" in some simplistic accounting software, which is confusing, because most finance and accounting professionals would reserve income for the "bottom line" results, not "top line" revenue or sales.
Cost of Sales - The direct expenses associated directly with the recognized Revenue for the period.
Gross Margin - The margin realized by subtracting the Cost of Sales from the Total Revenue.
Operating Income - An Earnings measure realized by subtracting the G&A Expenses from the Gross Margin.
Pre-Tax Profit - An Earnings measure that is the sum of the Operating Income and Total Other Income.
Net Income - An Earnings measure that is the result of subtracting Income Taxes from Pre-Tax Profit
EBITDA - An Earnings measure that is the result of adding back specific expenses (Interest, Taxes, Depreciation, and Amortization) to Net Income which is a measure of cash earnings without any regard to how the company is financed or taxed. This is a very popular measure, but is not a standard accounting term.
As you can see, there are several "Earnings" terms at various levels on an Income Statement.
For additional resources on this topic, please see the Finance and Accounting section of the and the Startup Financial Model.
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