Mastering Financial Tools287
positive or negative net income (net earnings)—and how much. This is why
the income statement is often referred to as the profi t-and-loss statement,
or P&L. The income statement also tells you the company’s revenues and
expenses during the time period it covers. Knowing the revenues and the
profi t enables you to determine the company’s profi t margins.
As we did with the balance sheet, we can represent the contents of the
income statement with a simple equation:
Revenues – Expenses = Net Income
An income statement starts with the company’s sales, or revenues.
This is primarily the value of the goods or services delivered to customers,
but you may have revenues from other sources as well. Note that revenues
in most cases are not the same as cash. For companies that use an accrual
method of revenue recognition (most larger companies), if a company de-
livers $1 million worth of goods in December 2018 and sends out an invoice
at the end of the month, for example, that $1 million in sales counts as
revenue for the year 2018 even though the customer hasn’t yet paid the bill.
Various expenses—the costs of making and storing a company’s goods,
administrative costs, depreciation of plant and equipment, interest ex-
penses, and taxes—are then deducted from revenues. The bottom line—
what’s left over—is the net income (or net profi t, or net earnings) for the
period covered by the statement.
Let’s look at the various line items on the income statement for Amal-
gamated Hat Rack in exhibit 16-3.
The cost of goods sold, or COGS, represents the direct costs of manu-
facturing hat racks. This fi gure covers raw materials, such as lumber, and
every thing needed to turn those materials into fi nished goods, such as
labor. Subtracting cost of goods sold from revenues gives us Amalgam-
ated’s gross profi t—an important measure of a company’s fi nancial perfor-
mance. In 2018, gross profi t was $1,600,000.
The next major category of cost is operating expenses, which include
the salaries of administrative employees, offi ce rents, sales and marketing
costs, and other costs not directly related to making a product or delivering
a service.