This time, let’s take a closer look at the income statement. Unlike the balance sheet or cash flow statement, the income statement is quite similar across most companies, making it relatively easier for beginners to understand. If we were to pick the three most important items in the income statement, they would be revenue, operating profit, and net profit. Among these, from revenue to operating profit, only the income and expenses related to the company’s core operations are recorded. From operating profit onward, events unrelated to the company’s main operations are recorded.
The starting point of the income statement is revenue. Simply put, when a company earns money through its core business activities, it is considered revenue. If we think about Starbucks, revenue would include not only beverages and food but also the various merchandise sold in their stores. However, if Starbucks were to earn money by investing in other companies or through an increase in the value of their real estate holdings, that would not be recorded as revenue. Instead, it would be recorded under other income, which appears further down on the income statement.
After revenue, there are two major expense categories: Cost of Goods Sold (COGS) and Selling, General, and Administrative Expenses (SG&A). These two categories include expenses strictly related to operations, and together they are referred to as operating expenses. Returning to the Starbucks example, COGS includes items directly related to revenue. For instance, the cost of coffee beans, syrups, and milk, as well as the depreciation of barista machines and the wages of baristas who make the coffee, all fall under COGS. On the other hand, SG&A encompasses all operating expenses that are not categorized as COGS. This includes a wider variety of costs, such as wages and depreciation that are not directly tied to revenue, marketing expenses, office rent, and research and development costs. These concepts will be covered in greater detail in sessions like the "Modeling 101" course.
Starting from revenue, the profit after deducting only the cost of goods sold (COGS) is called Gross Profit. When selling, general, and administrative expenses (SG&A) are further subtracted, the resulting profit is called Operating Profit. Operating profit reflects how much a company has earned purely through its core business activities, making it one of the most important indicators on the income statement. Typically, when a company announces its financial results, headlines in news articles or newspapers often highlight the operating profit. This is because operating profit is frequently used to evaluate how well a company performed during a specific period.
After operating profit, income and expenses unrelated to core operations are recorded. These typically include interest and taxes, as well as other income and other expenses. Other income and other expenses capture any financial gains or costs that are not connected to the company’s main business activities. Because of this, a wide variety of items can be recorded here. In fact, an accountant I know humorously refers to this section as the "trash bin" of the income statement. However, the most common entries in this section are profits or losses from investments. Examples include investment gains or losses related to real estate, losses from investments in other companies, or gains and losses due to foreign exchange rate fluctuations—all of which were mentioned when explaining revenue earlier.
From here, if we also subtract interest and taxes, we finally arrive at the endpoint of the income statement: Net Profit. Starting from revenue, this is the profit remaining after all the company’s expenses have been deducted. Quite a lot of steps to reach net profit, right? In fact, many companies often fail to turn a profit at the net income level. For now, I’ll keep the explanation of the items on the income statement to this basic level.
Before moving on to the balance sheet, let me briefly explain one key characteristic of the income statement. The order of the items listed on the income statement reflects the priorities of the company’s stakeholders. When a company earns revenue, the first priority is to cover operating expenses, such as employee wages and office rent. Only after these expenses are paid can creditors, like banks, collect interest. If there is still money left over, a portion is paid as taxes, which goes to the government. Finally, if there is any remaining profit, it becomes net profit, which is distributed among the shareholders.
What we can understand from this structure is the level of risk borne by each stakeholder. Who bears the least risk? It’s the employees. Unless the company is in extreme difficulty, wages are typically paid. Next, the bank has relatively low risk, followed by the government. The shareholders, however, bear the greatest risk. The advantage for shareholders, though, is that if there’s a significant surplus, all of it belongs to them. In other words, through the order of items on the income statement, we can observe the High Risk, High Return principle applied to shareholders.
So far, we’ve studied the income statement. We will delve into each aspect in greater detail as we continue to learn.
