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How to Read and Analyze an Income Statement

Heather Liston

7 min. read

Updated March 3, 2025

Ever feel a little left out when people start chatting about P&L’s? How about when the talk turns to income statements, or profit and loss reports, or even a “statement of activities”? 

The first bit of good news is that all of these refer to the same thing, so you may not have as much to learn as you thought. The second is that an income statement is based on a  few very simple concepts, which you already understand.

A quick overview of the main financial statements

The basic suite of financial statements a company produces on a monthly or quarterly basis, consists of thestatement of cash flows, thebalance sheet (or statement of financial position), and the income statement.

The Cash Flow statement shows how money moves in and out of your business over time. It shows where cash comes from (payments from customers, loans, investment, etc.) and where cash goes (bill payments, loan payments, etc.). This statement keeps track of how much cash you have in the bank at the end of each month. The Balance Sheet is an overview of your business’s health at a specific point in time. It shows what you own (assets) and what you owe (liabilities). 

Finally, the income statement details your business’s profits. It shows the revenue that your business is booking as well as the costs and expenses your business has incurred.

How an Income Statement Works

In its most basic form, an income statement is pretty straight forward. Here is a very simple example: 

Revenue (or Sales):

• Allowance          $2.00

Expenses:

• Candy               $1.50

Net Income (or Net Profit):               $ .50

See how that works? The top section lists money coming in during the period, the middle section lists money going out, and the bottom line is the difference between the two. All the math you need to produce or proofread this statement is a little basic subtraction.

Now flip open the annual report of any Fortune 500 company and find the income statement. What you see, in basic concept and structure, will be exactly like the one below. The only difference is that it has a lot more lines.

Most businesses have more detailed income statements than our simple example above. Let’s get into the details.

What is in an Income Statement

All income statements start with total revenue (or sales) at the top. Direct Costs (or “cost of goods sold” or “cost of revenue”) is listed next. Direct Costs are the expenses that are directly related to generating revenue. This could be manufacturing cost, the cost of the materials used, or inventory costs.

Direct Costs are subtracted from Revenue and the difference is shown as “gross profit”. Some income statements will represent this as a percentage and call it “gross margin”.  

After Gross Profit, an income statement will list all the rest of its operating expenses. These could be marketing expenses, administrative costs, rent, insurance, and research and development expenses. All regular expenses should be listed here.

All of the operating expenses are, then subtracted from Gross Profit, which leads to another sub-total called, usually, “operating income,” or, more jargonistically, EBIT or EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization). 

From there, interest and taxes (and maybe depreciation and amortization) have to be subtracted before the statement shows the final net income line. This final line is a business’s profit (or loss, if the number is negative).

This may sound complex, but it is nothing more than a little rearrangement of the basic elements—income and expenses—into some sub-categories. The same principles still apply, even when things start to look complicated. No matter what, the income statement includes just income, expenses, and differences between the two. And income is always listed before expenses in any group; it’s just that some companies do more sub-grouping before they get to their profits – the bottom line.

No matter what twists and turns you take along the way, the last number on the income statement is crucial. It is labeled “Net Income” above, but it also goes by names like “surplus,” “the bottom line,” or maybe “contribution to savings.” If the bottom line is a negative number, it will most often be called the “deficit” or “loss.” The math and the meaning are exactly the same; these are purely terminology issues.

Reviewing and Analyzing an Income Statement

If you’re asked to review an income statement and you’re not sure where to start, here are a few things to do:

1. Find the bottom line (Should be easy—it’s at the bottom)

On a very basic level, it’s good to see a positive number there. That means the company earned more than it spent during this period.  But if that bottom line is preceded by a minus sign, or printed in red, or enclosed in parentheses, then expenses exceeded revenue. Find out why. And what the plan is for making the red turn to black.

A net loss once in a while does not necessarily imply disaster. Sometimes new companies have a lot of start-up costs and do not expect to turn a profit in the first year or three. Or maybe the business in question is a cyclical one, like agriculture: if your company grows corn and there was no rain this year you will likely show a loss.  Perfectly normal; some years are up; some are down. On the other hand, if net losses become a trend, or if the company does not have enough cash to fund its expenses during the down times, there could be a problem.

2. Look at the sources of income

Do they make sense for the business? For example, if you’re in the cotton candy business, then sales income from the county fair sounds right. But if one income line is “gifts from friends” that’s probably not sustainable. What about next year when those friends don’t come through again?

Or say you’re reviewing the statements for a museum. Ten percent of their income came from admission fees last year and 90 percent came from ticket sales for a special blockbuster exhibit that came through town. Fine, as long as there will be a new blockbuster exhibit every year. If that was a non-repeatable event, though, you will want to ask questions about whether the revenue model is sustainable.

3. Look at the expense categories

Are they logical? For most businesses, you will see salaries and wages, insurance, rent, supplies, interest, and at least a few other things. Is anything missing that you would expect to see?  For example, if the business has a hundred employees and you don’t see rent, or mortgage interest, find out why. Is there an office? If not, why not? If yes, how is it being paid for?

4. Now look at the amounts: What are the biggest expenses?

If this is a service business, expect to see a large number for salaries. If it’s a manufacturing business, materials and supplies may logically be a significant total. On the other hand, what if you know the company has only three employees but the salary line is extremely high? Is someone being overpaid? Are there more people working there than you realized? Or what if the president told you the company has been profitable for years but you see high interest expenses? Find out why the company is borrowing money, and from whom, and whether they’re paying a reasonable rate.

5. Compare year-over-year numbers

Usually, the income statement will have separate column showing the figures for the prior year. If the document doesn’t already show the percentage change in every category, calculate those numbers yourself. Question any significant changes. Like, why is sales income 50 percent lower this year than last? Why is insurance 20 percent lower? Did the entity rack up such a great safety record that the insurer lowered its rates? Maybe. But maybe the reduced insurance number has a negative cause—like one of the policies was canceled and the company is at risk in some way.

6. Compare to the budget and forecast

Well run businesses will have an expense budget and revenue forecast that attempts to predict incoming revenue and outgoing expenses. If this is available, compare the actual income statement to the budget and forecast and look for numbers that are substantially different. You’ll want to see if the business is making its sales targets and if its costs are staying in control. If an expense is much higher than planned, you’ll want to dig into the reason why.

7. Think about logical relationships between numbers

For example, at most companies these days employee benefits (like health insurance, retirement plan contributions, parking passes) are a significant cost. If the salary line doubled but the benefits number went up by only 10 percent, that should strike you as odd. Is there some reason the new employees do not qualify for benefits? Did the company drop one of its benefit plans?

All these questions may have perfectly reasonable answers, but sorting through them will help you understand what’s going on, and give you confidence that you know what you’re talking about when it comes to income statements.

You do. Revenue minus expenses equals the bottom line. Everything else is details.

Ready to get started? Download our free Profit and Loss Template today. 

Heather Liston

Heather C. Liston is a San Francisco-based writer, specializing in financial topics.