As a working professional, business owner, entrepreneur, or investor, knowing how to read and analyze data from an income statement—one of the most important financial documents companies produce—is a critical skill to have.
In addition to helping you determine your company’s current financial health, understanding income statements can help you predict future opportunities, decide on business strategy, and create meaningful team goals.
If you don’t have a background in finance or accounting, it might seem difficult to understand the complex concepts inherent in financial documents. However, taking the time to understand financial statements, such as learning how to read an income statement, can go far in helping you advance your career.
To help you develop this understanding, here’s an explanation of everything you need to know about income statements—what they are, why they’re important, and how to analyze them—so you can get as much value out of these documents as possible.
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An income statement is a vital tool in financial reporting and one of the most common and critical statements you’re likely to encounter.
Also known as profit and loss (P&L) statements, income statements summarize all income and expenses over a given period, including the cumulative impact of revenue, gain, expense, and loss transactions. Income statements are often shared as quarterly and annual reports, showing financial trends and comparisons over time.
While the definition of an income statement may remind you of a balance sheet, the two documents are designed for different uses. An income statement tallies income and expenses; a balance sheet, on the other hand, records assets, liabilities, and equity.
An income statement reveals a company's financial performance over a specific period, narrating the story of the business's operational activities.
Within an income statement, you’ll find all revenue and expense accounts for a set period. Accountants create income statements using trial balances from any two points in time.
From an income statement and other financial documents—such as the cash flow statement, balance sheet, and annual report—you can determine whether the business is generating a profit, if it’s spending more than it earns, when costs are highest and lowest, how much it’s paying to produce its product, and whether it has the cash to invest back into the business.
Accountants, investors, and business owners regularly review income statements to understand how well a business is doing in relation to its expected future performance and use that understanding to adjust their actions. For example. a business owner whose company misses targets might pivot strategy to improve in the next quarter. Similarly, an investor might decide to sell an investment to buy into a company meeting or exceeding its goals.
While all financial data helps paint a picture of a company’s financial health, an income statement is one of the most important documents a company's leadership team and individual investors can review because it includes a detailed breakdown of income and expenses over the course of a reporting period.
These “buckets” may be further divided into individual line items, depending on a company’s policy and the granularity of its income statement. For example, revenue is often split out by product line or company division, while expenses may be broken down into procurement costs, wages, rent, and interest paid on debt.
There are two methods commonly used to read and analyze an organization’s financial documents: vertical analysis and horizontal analysis. The difference between the two is how a statement is read and the comparisons you can make from each type of analysis.
Vertical analysis refers to the method of financial analysis where each line item is listed as a percentage of a base figure within the statement. This means line items on income statements are stated in percentages of gross sales instead of in exact amounts of money, such as dollars.
In short, it’s the process of reading down a single column of data in a financial statement, determining how individual line items relate to each other (e.g., showing the relative size of different expenses, as line items may be listed as a percentage of operating expenses).
This type of analysis makes it simple to compare financial statements across periods and industries, and between companies, because you can see relative proportions. It also helps you analyze whether performance metrics are improving.
Vertical analysis isn’t always as immediately useful as horizontal analysis, but it can help you determine what questions should be asked, such as: Where did costs rise or fall? What line items are contributing most to profit margins? How are they affected over time?
Whereas vertical analysis focuses on each line item as a percentage of a base figure within a current period, horizontal analysis reviews and compares changes in the dollar amounts in a company’s financial statements over multiple reporting periods. It’s frequently used in absolute comparisons but can be used as percentages, too.
Horizontal analysis makes financial data and reporting consistent per generally accepted accounting principles (GAAP). It improves the review of a company’s consistency over time, as well as its growth compared to competitors.
Because of this, horizontal analysis is important to investors and analysts. By conducting a horizontal analysis, you can tell what’s been driving an organization’s financial performance over the years and spot trends and growth patterns, line item by line item. Ultimately, horizontal analysis is used to identify trends over time—comparisons from Q1 to Q2, for example—instead of revealing how individual line items relate to others.
The question isn’t whether you should leverage vertical or horizontal analysis when evaluating income statements. Instead, it’s: How can you best leverage both forms of analysis to uncover the information you need to make an educated decision? Utilizing both techniques can provide you with more insights than relying solely on one.
Here’s an example of an income statement from a fictional company for the year that ended on September 28, 2019.
