Profit and Loss : Understanding the Income Statement

When I first started in finance, I was overwhelmed with all the information we have to use to make decisions. However, I learned over the years that there are patterns and predictable systems for the way most financial statements work, and financials that don’t follow any rhyme or reason may indicate a disaster is afoot.

Virtually, all businesses have the same standard income statement, which can be a very powerful tool when you know how the system works. Each income statement has three principal components, which I will label as 1) Gross Profit, 2) Operating Expenses and 3) Other Income and Expenses.

The Gross Profit section describes what should be the beginning of the income statement. It looks at the gross revenue generated from a business’ principal activity, and it also looks at the cost of engaging in that principal activity. Consider a widget factory, where the gross revenue is the money collected from the sale of widgets, and then there will be a direct cost of the materials in the widget (or cost of goods sold). The difference between the revenue and the cost of inputs is the gross profit, and it tells us directly whether the principal activity of the company is viable.

Next comes the Operating Expenses. These are all the costs that cannot be directly allocated to the cost of making each widget. This will include the cost of utilities, the cost of administrative labor (like the HR manager and IT people), advertising, etc. If the gross profit can pay for all operating expenses, then there will be an operating profit available to the company. If the gross profit cannot pay operating expenses, then gross profit must be increased or operating expenses must be decreased.

Lastly, we have to examine Other Income and Expenses. These are sources of incomes and expenses generally not considered the principal activity of the company, and they may not be recurring. This might include the sale of an asset for a profit, or the one-time write-down of an asset due to an unexpected event like a fire. The operating profit remaining, after other income and expenses are accounted for, is called the Net Profit (or think of it as the FINAL PROFIT!)

Even financial institutions follow this pattern in their income statement. Interest income is the gross revenue, and interest expense is your cost of goods sold. The Net Interest Margin (NIM) is your gross profit. Operating expenses are straightforward and include employee wages and salaries, utilities, advertising, etc. Other income and expenses include origination fees and loan charge-offs.  An institution’s overall profitability is typically evaluated as Return On Assets (ROA), which is Net Profit divided by Total Assets.

If an institution wants to increase their ROA, they can simply consider their income statement basics: increase gross profit by growing interest income or reducing interest expense, lowering operating expenses, which can also help, and lastly, trying to boost other income sources (such as origination fees) and control other expenses (like loan charge-offs).