Your business is making money, and you’re thinking about getting a bank loan to expand. The bank wants you to verify your business’s profitability, and asks for a copy of your traditional income statement. Not sure what that is? You’re in the right place.
Here’s what you need to know about traditional income statements, how to calculate them, and how to use them in your business accounting
What is a traditional income statement?
A traditional income statement is a formal presentation of all income and expenses of a business for a particular period of time. The presentation includes a calculation of revenue minus expenses, showing whether the business generated a profit (net income) or a loss. This is why an income statement is also called a profit and loss statement (P&L).
Components of traditional income statements
- Cost of goods sold (COGS)
- Gross profit
- Selling, general, and administrative expenses (SG&A)
- Operating profit/income
- Interest expense
- Pretax profit/income
- Income tax expense
- Net income
Traditional income statements have several key components, starting with sales or revenue at the top line, down through net income at the bottom line. Depending on the level of detail and transparency provided by a company, each component may have more than one line of data. Because of the guidelines in generally accepted accounting principles (GAAP), which publicly traded companies must follow, traditional income statements typically use the following format:
This line item summarizes total income for a period, usually a quarter or a year. For most companies, revenue consists largely of sales. Some industries, such as retailers, report total sales as well as net sales, which accounts for customer returns of merchandise.
Revenue is mainly from a company’s core operations—routine sales of products or services. It may also include income from sources that aren’t part of the company’s regular business, called non-core operations. This can include income from discontinued operations, which the company has decided to sell or shut, as well as income from investments, royalties, and fees.
If a hypothetical company called Widget Wizard Inc. had only operating revenue and no other income, the entry would appear as:
|Other income||$0 million|
|Total revenue||$100 million|
2. Cost of goods sold (COGS)
This tallies the costs to produce goods or services sold in the period. It includes direct costs such as raw materials, production labor, and shipping. GAAP also requires companies to include some portion of their indirect expenses—called selling, general, and administrative costs (SG&A)—in calculating COGS. This is known as absorption-costing or full-costing, and it allows companies to reflect all of the costs of production. An alternative called variable costing excludes indirect costs for a lower COGS.
Using absorption costing, for example, Widget Wizard’s cost of goods sold might be $30 million, while with variable costing, COGS might be only $25 million.
3. Gross profit
Gross profit represents total revenue minus the cost of goods sold. It’s the first measure of a company’s profitability, before other expenses are counted. For example: Widget Wizard had $100 million sales, minus $30 million of COGS, for $70 million in gross profit. Companies also frequently express gross profit as a percentage of sales, known as the gross margin.
The formula for determining gross margin is:
(Total Revenue - COGS) / Total Revenue = Gross Margin
In Widget Wizard’s case, gross margin is:
($100 million - $30 million) /$100 million = 0.7 or 70%
4. Selling, general, and administrative expenses (SG&A)
These are expenses incurred while operating the business and not directly related to production. They are reported separately from COGS in the income statement and include expenses for salespeople and office staff, marketing and advertising, rent for office space, and utilities. They’re sometimes known as fixed costs or overhead costs. Depending on a company’s transparency, these may be listed individually under the heading SG&A.
Widget Wizard’s selling, general, and administrative expenses totaled $25 million for the period.
5. Operating profit/income
This is gross profit minus SG&A expenses. Operating profit, or operating income, is the amount left after all internal costs—COGS and SG&A—are subtracted. Operating profit also represents the amount of working capital available to the company, some of which may be used for investment, as well as paying interest on any debt obligations and income taxes, which are considered external costs beyond the company’s control.
The calculation for operating profit is:
Gross Profit - SG&A = Operating Profit
Widget Wizard’s operating profit in this scenario would be:
$70 million - $25 million = $45 million
Operating profit also is frequently expressed as a percentage of sales minus the operating margin. In the case of Widget Wizard, the calculation would be:
$45 million / $100 million = 0.45 or 45%
6. Interest expense
Any interest on business loans or other debt obligations must be paid from operating profit. The interest is tax-deductible.
The formula to calculate this is:
Loan Amount x Interest Rate = Interest Expense
Let’s imagine Widget Wizard obtained a $50 million loan for expansion a year ago, and the annual interest rate is 10%. Annual interest on the loan is:
$50 million x 0.10 = $5 million
7. Pretax profit/income
Debt interest expense is deducted from operating profit, to determine a company’s taxable income.
To calculate this, the formula is:
Operating Profit - Interest Expense = Pretax Profit
For Widget Wizard, pretax profit then is:
$45 million - $5 million = $40 million
8. Income tax expense
A company’s income tax expense is determined by the amount of pretax profit times the applicable tax rate percentage. The formula is:
Pretax Profit x Tax Rate = Income Tax Expense
For Widget Wizard, let’s assume a tax rate of 20%. So tax expense is:
$40 million x 0.20 = $8 million
9. Net income
Finally, the bottom line—the result of subtracting all expenses, interest, and taxes from a company’s revenues.
The formula to calculate this is:
Operating Profit - Income Tax Expense = Net Income
In Widget Wizard’s case, net income is pretax profit minus taxes:
$40 million - $8 million = $32 million
Net income also is often expressed as a margin, or what percentage of revenue ends up as net income. For Widget Wizard, the net profit margin would be:
$32 million / $100 million = 0.32 or 32%
Example of a traditional income statement
Below is a hypothetical traditional income statement format for Widget Wizard, in standard format, including the heading with the company name and the reporting period. For an annual income statement, a company will compare the most recent year against the prior year. Quarterly income statements compare the most recent quarter against the same quarter a year prior.
The heading also will indicate the scale of values displayed, typically in thousands or millions of dollars, and the currency used.
Cost of goods sold
Selling, general, admin. expense
Profit before tax
Income tax expense
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Traditional income statements FAQ
What are the advantages of using traditional income statements?
Traditional income statements have two main advantages: they meet GAAP accounting standards, and they are acceptable to lenders and equity investors in deciding whether to provide capital to companies.
What are the disadvantages of traditional income statements?
A traditional income statement, using the absorption-cost or full-cost method of accounting for cost of goods sold, must estimate allocations from various accounts for some of the costs. That can make it difficult to know how much these costs change when sales change.
What are the differences between traditional and contribution margin income statements?
Both statements will produce the same net income number, but they differ in how they arrive at the bottom line. Traditional income statements account separately for direct product costs (COGS), which may be a combination of variable costs and fixed costs, and indirect costs (SG&A). A contribution margin statement separates variable expenses and fixed costs.