Financial statements: income statement - CCEA

Key facts about income statements

• An income statement shows a business's revenue and costs to determine profit, including sales revenue, cost of sales, gross profit, expenses, and net profit.

• It demonstrates financial performance over a period, typically 12 months, and includes key financial information.

• Produced annually, it shows profit or loss over the past year by calculating revenue and costs.

• Used to compare performance with previous years and competitors, and by stakeholders for decision-making.

What is an income statement?

An income statement shows the revenue and costs of a business. This is used to work out whether or not the business has made a profit.

What are the main components of an income statement?

Sales revenue – this is the money coming into the business from selling goods or services. It can also be referred to as sales turnover.

Cost of sales – these are the direct costs of supplying the goods or services such as wages, buying raw materials to make the products, packaging costs and energy costs such as gas and electricity.

Gross profit – this is the revenue minus the cost of sales. This figure does not take into account any other expenses involved in running a business. The calculation would look like this:

Revenue – Cost of sales = Gross profit

Expenses (overheads) – these are the costs that do not change as production increases or decreases. This includes interest paid on loans, insurance, salaries and maintenance costs.

Net profit – is the last stage of the income statement. Net profit allows a business to measure their overall financial performance to see if they are successful or not in a given time period. The calculation would look like this:

Gross profit – Expenses = Net profit

The income statement is a financial document that demonstrates the financial performance of a business based on its income and how this has changed over a period of time, usually 12 months. The income statement allows owners to monitor business performance in line with business objectives and the rest of the industry. The key information shown on an income statement includes information about revenue, cost of sales, and any other expenses, along with gross and net profit.

Example of an income statement:

Income statements are normally produced every year, showing the profit or loss made over the past 12 months. This is known as the trading period.

A business will have to:

• calculate revenue for the trading period by working out how many products they sold and what price they sold them for

• calculate the costs of the business for the trading period

• split the costs into the cost of sales and expenses.

How does a business interpret income statements?

Comparison with last year

One way a business can use an income statement is to compare their figures against how the business performed in the previous year. This will show them if they have improved the business by increasing the revenue, gross or net profit.

Comparison with competitors

Another way a business can use income statements is to compare their data to their competitors. Businesses that are making more revenue than their competitors will have more market share. Businesses that are making more net profit may be a more attractive investment or have more finance available to develop new products.

Stakeholders and income statements

There are many stakeholders that will be interested in the income statement of a business:

• managers will use income statements to help them make decisions

• shareholders will use income statements to help them decide whether or not to invest money into the business or whether to sell their shares

• employees could use an income statement to support their demands for higher wages, they can also see how secure their job is likely to be

• the government will use the income statement to see how much tax the business needs to pay.

It is important to understand the difference between gross and net profit. Knowing the gross profit margin and net profit margin is essential when making business decisions.

Changing prices

One way a business can improve its profits is to try and make more revenue. They can do this by increasing their selling price: if they can maintain the same level of demand after this they will make more profit.

This is more likely if they don’t have many competitors.

In some cases, reducing prices could lead to an increase in demand that is big enough to increase profits overall.

For example, if a business is selling 10,000 products at £10 each, their revenue is £100,000. If they reduce prices to £9 and demand increases to 12,000 units, their revenue will be £108,000.

Reducing costs

Another way to increase profits is to reduce costs. This could include:

Reducing the cost of raw materials – this would reduce the cost of sales but could have an impact on the quality of the product.

Reducing labour costs – some businesses have introduced technology to reduce their wage costs. An example of this is self-service tills in supermarkets and online check-in for flights. However, the initial set up of technology can be costly and it could be unpopular with customers.

Reducing expenses – this could reduce costs such as insurance costs or finding lower interest rates without impacting the quality of the product or service.

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