What you will learn
- Read an income statement from the top line down to the bottom line
- Define revenue, COGS, gross profit, operating income, and net income
- Calculate gross profit and net income from a simple set of figures
- Explain why revenue can rise while profit falls
The income statement, also called the profit and loss statement or P&L, answers one simple question: over this period, did the company make money, and how? It reads from top to bottom like a funnel. It starts with total sales at the top and subtracts costs in layers until it reaches profit at the bottom. Once you can follow the funnel, you can see exactly where a company earns and where it loses its money.
The income statement for beginners (Accounting Stuff)
A clear walk down the income statement funnel. Follow along and note how each cost is subtracted in layers to reach net income.
Walking down the funnel
- Revenue, the top line: total sales of goods or services before any costs are taken out.
- Cost of goods sold, or COGS: the direct costs of producing what was sold, such as materials and direct labor.
- Gross profit equals revenue minus COGS: what is left to cover everything else.
- Operating expenses: the indirect costs of running the business, including SG&A (selling, general, and administrative) and R&D (research and development).
- Operating income, also called EBIT (earnings before interest and taxes), equals gross profit minus operating expenses: the profit from core operations.
- Interest and taxes: the cost of borrowing and the government's share.
- Net income, the bottom line: the final profit left for shareholders after everything is subtracted.
Key terms
- Revenue (top line)
- Total sales before any costs. The starting point of the income statement.
- COGS
- Cost of goods sold, the direct cost of making or delivering what was sold.
- Gross profit
- Revenue minus COGS. What remains to cover all other costs.
- Operating income (EBIT)
- Gross profit minus operating expenses. Profit from the core business, before interest and taxes.
- Net income (bottom line)
- The final profit after every cost, including interest and taxes, is subtracted.
Following one company down the funnel
A company reports the following for the year. Work down the funnel to find each layer of profit.
- Revenue. Sales for the year are 1,000,000 dollars.
- Subtract COGS of 600,000. Gross profit is 1,000,000 minus 600,000, which is 400,000.
- Subtract operating expenses of 250,000. Operating income (EBIT) is 400,000 minus 250,000, which is 150,000.
- Subtract interest of 30,000, then taxes of 30,000. 150,000 minus 30,000 interest is 120,000 before tax, and minus 30,000 tax leaves 90,000.
Why it matters: Each layer answers a different question. Gross profit shows production efficiency, operating income shows the core business, and net income shows what is finally left for owners.
| Line | Amount |
|---|---|
| Revenue | $1,000,000 |
| Less: COGS | ($600,000) |
| Gross profit | $400,000 |
| Less: operating expenses | ($250,000) |
| Operating income (EBIT) | $150,000 |
| Less: interest and taxes | ($60,000) |
| Net income | $90,000 |
Calculate gross profit
A company has revenue of 800,000 dollars and cost of goods sold of 500,000 dollars. What is its gross profit?
Top line and bottom line
The nicknames come straight from the layout. Revenue sits at the top, so it is the top line, and net income sits at the bottom, so it is the bottom line. Here is the key insight: a company can grow its top line while its bottom line shrinks, if costs rise faster than sales. That is why analysts never look at revenue alone. Each layer of the funnel tells a different part of the story.
Revenue is vanity, profit is sanity. The income statement shows you the journey between the two.
Sales up, profit down
This year a company's revenue grew from 1,000,000 to 1,200,000 dollars, but its net income fell from 100,000 to 70,000. What is the most likely explanation?
When expenses rise faster than revenue, net income can fall even though sales rose. Always read past the top line.Remember: this is accrual, not cash
One reminder from the last lesson. The income statement is built on accrual accounting. Recorded revenue does not mean the cash has arrived, and recorded expenses do not mean cash has left. A company can report a healthy net income while its bank balance actually falls. That is exactly why the cash flow statement, coming up soon, is so important. The income statement tells you about profitability. It does not directly tell you about cash.
Introduction to the income statement (Khan Academy)
A second, calm walkthrough tying revenue and expenses to net income. Watch it to reinforce the funnel with a different teaching style.
Which layer would you check?
Imagine a company's net income fell this year. Explain which layers of the income statement you would compare to last year to find out why, and what each layer would tell you.
Write an answer before comparing it with the model response.
Model answer
I would compare each layer against last year. If gross profit fell, production or input costs rose relative to sales. If gross profit held but operating income fell, overhead like SG&A or R&D grew. If operating income held but net income fell, higher interest or taxes were the cause. Comparing layer by layer isolates exactly where the profit leaked out.
You can now read a company's profit from top to bottom. Next we turn to the balance sheet, the snapshot of what a company owns and owes, and the one equation that always has to hold.