Learn to read, understand and interpret an income statement

As we saw in the previous chapter, financial statements include two fundamental documents for understanding a company's health: the balance sheet and the income statement. In this course on corporate management and finance, we will focus on the income statement, which is the most understandable document for a beginner, and we will then look at the balance sheet.

Simple Definition of Income Statement

Unlike the Balance Sheet, which is a document that presents, in a way, the assets of a company, with all the history, the income statement lists the income and expenses of the current accounting year (one-year period), in order to estimate a company's performance and profitability.

The income statement allows you to calculate the company's net profit, which can be positive or negative. It is important to understand that this table only takes into account the financial year in question, and thus allows the entrepreneur or decision-maker to know whether the company's current economic model is profitable or not, and to calculate certain ratios.

Official structure of the income statement

The income statement has two main categories: the company's expenses on one side, and its revenues on the other. Revenues represent what makes the company richer, i.e., its profits. Expenses represent everything the company has to pay and what makes it poorer.

It allows you to know whether, during a given period (for example, the past year), the company has made or lost money, quite simply. This differs from the balance sheet, which shows what the company owns and what it owes (or in other words, what it finances and with what resources).

The income statement is a legally required summary document that every company must produce according to established standards and best practices. However, once the standard legal statement has been generated based on the official template, more analytical and tiered versions can be created, with adjustments tailored to the specific business activity and financial analysis needs.

Here is the "official" French form, according to the General Accounting Plan, which is a form "by nature", and which differs from the Anglo-Saxon form called the "by function" form, which we will discuss later:

In this table, we will see what each item represents, both in terms of revenue (on the left) and expenses (on the right). But before that, allow me a brief digression related to the General Chart of Accounts.

The General Accounting Plan

In the General Accounting Plan (PCG), a French document that classifies all of a company's financial accounts (Purchases of Goods, Personnel Expenses, etc.), accounts are grouped by class and assigned a number. For example, Personnel Expenses are in account 64.

I will return to the PCG in detail later, especially for the French reader, because this document specifically concerns French standards, but so that everyone can understand: the PCG basically allows you to find the account number concerned by an accounting transaction.

In the French General Accounting Plan (PCG), all accounts related to the income statement are found in classes 6 (expense accounts) and 7 (revenue accounts). All other accounts relate to the balance sheet.

The international equivalent of the PCG is IFRS standards.

Here is an image that gives you an idea of the accounts contained in the PCG, and the income statement here contains columns 6 and 7, and the operating expenses accounts 60 to 65, as well as account 68:

If this document is unfamiliar to you at this stage, don't worry: I'll explain it later. For now, all you need to understand is that the French Generally Accepted Accounting Principles (PCG) list each account (expense or revenue account, or balance sheet account). Regarding the income statement, French accounting standards assign a number to each expense or revenue account, allowing for account classification and easy identification during the accounting process.

If you are an international reader, the PCG does not concern you, and we will come back to IFRS standards later.

This aside was simply intended to explain why, in the rest of this course, some accounts will be numbered, in order to begin to raise awareness about these numberings, especially for the French reader of this course.

Let's now return to the income statement.

Link between profit and loss account by nature and GIS

Intermediate management balances (IMBs) are management indicators used to assess a company's management from an analytical perspective. Put simply, they allow for the breakdown of the income statement to explain and analyze the final net result.

What is interesting about the official structure of the income statement, the one recommended by the French PCG, is that this structure allows the income statement to be broken down into a table with different intermediate balances: the operating result (related to the operation of the company, therefore to its main activity), the financial result (related to the financial policy of the company, therefore the cost of debt for example, or the gain related to its financial investments, investments which are not the main activity of the company), and finally the extraordinary result (therefore the gains and losses related to exceptional events which are not part of the main activity of the company).

Let's take the profit and loss statement we saw above and break it down into different balances to better understand the logic behind the profit and loss statement:

It is the sum of these different balances that allows us to arrive at the net result, and above all to explain it, because two companies can have a similar net result, but one may be very efficient operationally, while the other may be in great difficulty, and the net result of the second may be "inflated" by the sale of an asset for example, which is a completely exceptional activity and not the main activity of the company.

Now that we understand that, I suggest we review each item in the income statement to fully grasp these concepts for the rest of the management and finance course. Let's start with revenues, and then we'll look at expenses.

Products in the income statement

There are 3 types of products, symmetrically corresponding to the 3 types of charges that we will discuss later:

• operating income, which relates to the profits made by the company in the course of its normal and main business activity; ;
• financial products, which relate to the gains made by the company as part of its financial investments, for example; ;
• and exceptional products, which relate to gains made by the company in the context of its exceptional activities, in the accidental sense of the term (for example, exceptional insurance compensation, donations received, exceptional subsidies, gains related to the sale of assets).

Operating income

Operating income, as we have just seen, is all the wealth generated by the company as part of its main activity.

These products are grouped in France in accounts 70 to 75 of the General Accounting Plan (don't worry, we will come back to this a little later in this course).

Here is a brief overview of the different operating products, and we will then move on to financial products, and then to exceptional products.

Net revenue

It's simply the turnover, or the company's revenue. But be careful, it's important to understand what turnover includes, because in the official French presentation of the income statement, turnover is not itemized.

In fact, net revenue includes all billings related to the company's main activity, and depending on the nature of this activity, it comes from the following items:

• Sales of goods (account 707 of the PCG) → typical of trading companies (buying/reselling).
• Services provided (account 706) → firms, consultants, services.
• Sales of finished products (account 701) → industrial or craft businesses that manufacture/process

These amounts are aggregated into a single line "Net Sales" in the official income statement.

The breakdown by type (701 vs 706 vs 707) usually appears in the appendix or in the SIG (intermediate management balances) when analyzing the gross margin vs. the added value, and we will do a course specifically dedicated to the added value and the SIG later.

Furthermore, it is important at this stage to understand that there are 3 main types of business activities, and depending on the type of activity, the "analytical" profit and loss statement, which will be more detailed, will be presented more or less differently:

• trading activity (buying/reselling); ;
• industrial or craft activity (transformation of raw materials into finished products); ;
• provision of services (consulting for example).

And obviously, a company can have several activities, which won't make our task any easier later on for the financial analysis, but we'll come back to that 🙂

Finally, another important detail to remember is that when we talk about purchasing goods, we're referring to trade (buying and reselling), and when we talk about raw materials, we're referring to industry or crafts (ultimately, the transformation into finished products). Understanding these concepts is crucial to avoid confusion later on.

So, getting back to the revenue, it includes all this data:

Net sales revenue = Sum of current sales (excluding taxes, net of discounts/returns)
= Sales of goods (707)
+ Sales of finished products (701)
+ Services (706)
+ Other sales related to ordinary activities (704, 705, 708 if principal…)

Stored production

After revenue, we find inventory. This refers to finished (or work-in-progress) products manufactured by the company during the fiscal year, but which have not yet been sold. They are valued at their cost price (and not at the selling price).

To estimate the stored production, the formula is as follows:

Stored production = ending inventory – beginning inventory

• If the ending stock is greater than the beginning stock → positive value → added to operating income (the company has created more wealth than it has sold).
• If the ending stock is less than the beginning stock → negative value → subtract products (the company has sold part of the stock produced in previous years).

This line item therefore allows us to record not just sales, but the actual production for the period. Note: this does not include raw materials (which are recorded as expenses through changes in raw material inventory; we will return to this later).

Fixed production

Next, we have capitalized production. These are also finished products produced by the company, but which are capitalized, meaning that the company will ultimately use them as production tools. For example, a car manufacturer that makes a certain stock of cars available to its sales representatives. Or a restaurant that prepares meals and makes some of those meals available to its employees.

Operating grants

Next, we have operating subsidies. These are funds that public authorities make available to businesses to help them with their operations. They should be distinguished from investment subsidies, which are also public aid but are granted for long-term investments, not for operations (which are short- or medium-term).

Other operating income

Next, we have other operating income, which relates to revenue received for products or services not connected to the company's core business. For example: royalties received for a patent, income from renting buildings not used in the company's main business, miscellaneous operating income, etc.

Reversals of depreciation and provisions

Reversals are products corresponding to the cancellation (total or partial) of depreciation or provisions made in previous years, when the risk or wear and tear turns out to be less than expected.

Examples:

• reversal of a provision for doubtful debts which had become unnecessary (we had prudently charged a sum "blocked" in case a customer did not pay, or in anticipation of a lawsuit); ;
• reversal of depreciation on inventories, etc.

These recoveries are the exact counterpart of the allocations that will appear later as expenses.

If at this stage the jargon still seems a little opaque to you, no worries: everything concerning depreciation and provisions will be explained in detail in the following chapters.

For now, simply remember that in operating income, these reversals represent a "gain": a charge incurred prudently that is no longer necessary is cancelled.

We have now seen all the operating-related items in the income statement, and we will now review the related items

Financial products

Like financial expenses, financial income is income earned through investments, for example. These are therefore financial investments held by the company, although financial income also includes discounts obtained.

Exceptional products

And finally, we have exceptional products, which include everything the company has received in connection with exceptional issues that do not relate to the company's main activity, such as fines or penalties.

Expenses in the income statement

Now that we've reviewed the products, let's move on to the expenses. In the income statement, you'll find 3 types of expenses.

Operating expenses

These are all the expenses linked to the operation of the company, therefore to its main activity, for example:

• Purchases of raw materials
• Purchases of goods
• Change in inventories (of raw materials and goods)
• Wages
• Endowments
• Others
• Taxes and duties (excluding corporate income tax)
• External charges:
  • Insurance premiums
  • Rents
  • Electricity, gas, water…

Operating expenses include all accounts from 60 to 65, as well as account 68.

Accounts 60 to 65 include purchases, stock variations, expenses related to external services, taxes, etc. In short, everything we have seen above.

Regarding depreciation and provisions (account 68)

Regarding account 68, I could dedicate a whole chapter to it, but it essentially deals with depreciation and provisions. To put it very briefly, as we mentioned earlier in the section on reversals of depreciation and provisions, a depreciation expense is an accounting entry that occurs when a company acquires, for example, a large machine (called a tangible fixed asset) intended for use over several years: it is therefore decided to depreciate it, that is, to spread its cost over several years.

Therefore, to reflect a picture true to reality, the entire amount spent on this machine is not recorded in the income statement as an expense (which could "weigh down" the net result), but the amount is "broken down" into several annual amounts called depreciation.

This prevents an excessive increase in the company's expenses for a given year, even though the machine will be used for several years.

In other words, this expense is smoothed out to reflect reality. Furthermore, from a strategic perspective, this helps improve the company's net profit over the past year, since the expense is spread over several years.

Conversely, if the company wishes to reduce its profit (for tax reasons, for example), it may be in its interest not to amortize a purchase.

After operating expenses, we therefore have, symmetrically to revenues, financial expenses and extraordinary expenses.

Regarding the change in raw material stock (intended for processing)

Remember, in the section on operating products, we were able to estimate the stored production using the following formula:

Stored production = Ending inventory – Beginning inventory

This allowed us to determine the relative value of finished or work-in-progress products that the company had transformed from raw materials for resale. This calculation then made it possible to determine whether the company had more or less finished goods inventory at the end of the fiscal year than at the beginning.

• If the ending inventory is greater than the beginning inventory → positive value → this amount is added to operating revenues. The company has produced more than it has sold: this additional production is wealth created this year.
• If the final stock is less than → negative value → we subtract this sum from the products.

But regarding the variation of raw materials, it is exactly the same logic, except that we just have to reason symmetrically, because this item concerns expenses (impoverishment of the company) and not products (gains), since it is a cost for the company that buys raw materials.

So in the case of raw materials, we seek to reflect in the income statement the actual cost of the materials consumed during the financial year (not just those that were purchased).

The formula for the change in inventory (account 6031 for raw materials) is therefore as follows:

Variation = Initial stock – Final stock

You will notice that here, we reverse the calculation, placing the initial stock before the final stock:

• If ending stock > beginning stock (more has been stocked) → negative change → This value is subtracted from operating expenses. → Why? Because the additional materials purchased have not yet been used this year. We don't want to count them as an expense now. (they will be next year when we use them).
• If ending stock < beginning stock (stock has been destocked) → positive change → This value is added to operating expenses. → Why? Because, in addition to the year's purchases, materials that were already in stock at the beginning of the year have been consumed. Therefore, expenses must be increased to reflect the true cost of production/sales for the fiscal year..

The logic is therefore identical in spirit (adjust to respect the principle of exercise: expenses/products of the year concerned), but the direction of the calculation and the sign are reversed because we are on the side of expenses (materials consumed) and not of products (production created).

Regarding the variation in inventory of goods (purchase/resale)

Moreover, this logic applies equally to raw materials, which we have just seen here, and to goods, which are intended to be resold without transformation.

For goods (purchase/resale without transformation) → it's exactly the same logic as for raw materials:

Change in merchandise stock = Beginning stock – Ending stock (account 6037).

It also appears in operating expenses, right after "Purchases of goods".

The case of goods purchased but not yet sold

Unlike finished products manufactured by the company (which result in "stored production" as operating products), Goods intended for purchase/resale never generate revenue until they are sold.. They simply remain recorded as assets on the balance sheet (account 37 – Merchandise inventory).

Their only impact on the profit and loss account is through the change in inventory of goods (account 6037), which appears in operating expenses and allows the "Purchases of goods" to be adjusted to include only the cost of goods actually sold during the financial year.

Summary of finished products / goods

The simple rule to remember:

• What is manufactured by the company and not sold → is added to products (stocked production).
• What is purchased (materials or goods) and not yet consumed/sold → is removed from expenses via the negative inventory change.

Here is a summary table:

These concepts are somewhat counterintuitive, which is why it's important to fully grasp them. It's simply a matter of developing a mental exercise.

Two equivalent ways of accounting for stored production

Important note: some works explain stored production differently. They say that "the cost of goods sold is deducted from expenses.".

In reality, this amounts to exactly the same as adding the stored production into products.

Example: if you manufacture €50,000 worth of unsold products, you can either:

• add +€50,000 in products (stockpiled production valued at cost price, which is an expense); ;
• either deduct the €50,000 cost price from the production costs.

The net result is identical. The French General Accounting Plan chooses the first solution to better show the wealth actually created during the financial year.

Financial charges

As their name suggests, financial expenses are costs related to financial issues, such as loan interest. These expenses are deducted from financial income, resulting in the financial result, which is often a minor factor in the profit and loss statements of small and medium-sized enterprises.

Exceptional charges

Finally, we have exceptional expenses, which are linked to unforeseen circumstances, such as a fine. These are expenses unrelated to the company's core business. It's important to monitor them, just as you would exceptional income, because a year's income statement can appear "abnormal" compared to usual due to exceptional expenses or income that don't reflect the company's long-term performance.

The various results of the income statement

Now that we have a good understanding of each load and product heading, the 4 types of results mentioned at the beginning of this chapter take on their full meaning:

• The operating result (which we hope is positive) measures the margin linked to the company's operations; it is the most important indicator.
• The financial result and the exceptional result estimate the financial and exceptional margins (which can be negative without this being a problem).
• And finally, the net result is equal to the operating result + financial result (or – financial result if this is negative) + exceptional result (or – exceptional result if this is negative).

The income statement therefore allows us to identify 4 types of results:

• Operating result:

This is the difference between operating income and operating expenses. It represents what the company "earns" from its core business, its operations.

Example: for a restaurant, it is simply the sales from which we subtract the purchases of goods, and all the expenses related to the operation (for example rent, salaries, etc.).

• The financial result:

This refers to financial products (e.g., investments) less financial expenses (e.g., interest from bank loans).

This result is often negative for many companies, but the amount is often marginal, so there is no need to worry, since these are not items related to the company's core business.

• The exceptional result:

Here, we are talking about exceptional products (example: a donation, a sale of equipment, or any other enrichment which is exceptional) less exceptional expenses (example: a fine, a settlement following a Labour Court, etc…).

Here again, with some exceptions, the often negative result is not alarming, because it is supposed to remain marginal compared to movements linked to the company's activity.

• The net result

In the net result, we add:

Operating result + Financial result + Exceptional result – Employee profit-sharing – Corporate tax.

In France, participation is a employee savings scheme ensuring the redistribution, for the benefit of employees, of a portion of the company's profits. It is therefore removed from the net result, in the same way as corporate tax, in order to have the net result, therefore the final margin of the company.

It's this net income that will tell us whether the company is profitable or not. And this net income will be added to the Equity, in the Liabilities section of the company's Balance Sheet, but don't panic, I'll explain all that in the next chapter.

Theoretical table of the income statement according to the list presentation of the French PCG (commonly used for SMEs)

Here is a detailed view of the Income Statement based on the French General Accounting Plan, to give an idea of each expense account and each income account.

INCOME STATEMENT (financial year from __/__/____ to __/__/____)

I – OPERATING PRODUCTS: income generated by the company’s main activity

• Net sales revenue: total sales after deductions such as discounts or returns (which includes the production of goods and services sold)
• Stocked production: value of products manufactured but still in stock, not sold
• Fixed assets: value of products manufactured for internal use by the company, such as machinery
• Operating subsidies: financial aid received from the State for current activity (and not for long-term investment)
• Other income: miscellaneous income related to the activity, such as rent received
• Reversals of depreciation and provisions: recovery of amounts previously set aside for wear and tear or risks

II – OPERATING EXPENSES: expenses related to the company’s main activity

• Purchases of goods: cost of products purchased for resale as is (purchase/resale)
• Change in inventory: This is the difference between the inventory at the beginning and end of the year. If there is more inventory at the end of the year than at the beginning, then the change in inventory is negative because the inventory has increased. We must therefore deduct this inventory from expenses (hence the negative value), because we have not yet sold these goods. This is counterintuitive, but it is due to the fact that we should not count the expenses related to purchasing goods and unsold inventory twice. We have already explained this earlier in this course, and we will provide more detailed explanations in future courses.
• Purchases of raw materials and other supplies: cost of materials used to manufacture products
• Change in raw material inventory: Same logic as for the change in merchandise inventory. Change = Beginning inventory – Ending inventory. If positive because the ending inventory would be lower than the beginning inventory, it means that more raw materials were sold than purchased, so operating expenses are increased to reflect the additional cost of materials consumed (from old inventory), so that the income statement shows the true production cost for the year.
• Other purchases and external expenses: expenses such as rental, advertising or external services
• Taxes, duties and similar payments: compulsory payments to the State, excluding income tax
• Wages and salaries: remuneration paid to employees
• Social security contributions: social security contributions paid for employees, such as social security
• Depreciation and provisions: amounts set aside for wear and tear of assets or future risks
• Other expenses: miscellaneous expenses related to the activity, not classified elsewhere

→ Operating result (I – II): profit or loss from the main activity, before finances and exceptions

III – FINANCIAL PRODUCTS: income related to finances, such as investments

• Equity income: income from shares held in other companies
• Other interest and similar income: interest received on loans or investments
• Reversals of provisions and transfers of charges: recovery of amounts set aside for financial risks

IV – FINANCIAL CHARGES: expenses related to finances, such as loans

• Interest and similar charges: interest paid on debts or loans
• Provisions: amounts set aside for future financial risks

→ Financial result (III – IV): gain or loss from financial transactions

→ Current result before tax (Operating result + Financial result): total gain or loss from normal activity, before taxes and exceptions

V – EXCEPTIONAL PRODUCTS: unusual income, not linked to current activity

• Income from management operations: exceptional gains on unusual current sales
• Capital gains: gains on the sale of major assets, such as a building
• Reversals of provisions and transfers of charges: recovery of amounts set aside for exceptional risks

VI – EXCEPTIONAL CHARGES: unusual expenses, not related to current activity

• Expenses on management operations: exceptional losses on current operations
• Capital transaction charges: losses on the sale or destruction of significant assets
• Provisions: amounts set aside for future exceptional risks

→ Exceptional result (V – VI): gain or loss from unusual events

VII – Employee profit sharing: share of profits paid to employees, if applicable

VIII – Profit tax: tax paid on the company’s profits

→ NET RESULT FOR THE YEAR (Profit or Loss): final gain or loss of the year, after all

Profit and loss statement analysis tools: Intermediate Management Balances (IMBs)

Even though the official income statement is presented "by nature" (PCG), managers and analysts often analyze it in a tiered form using GIS, as we said previously.

These intermediate indicators (not mandatory, but very common) allow profitability to be tracked step by step.

Here is the most classic breakdown (from a "commercial/industrial" perspective):

Turnover
– Direct costs (purchases, materials, subcontracting)
= Gross margin
– Operating expenses (salaries, rent, etc.)

+ Operating subsidies
– Taxes and duties (excluding corporate income tax)
= Gross Operating Surplus (EBE) ← approximate equivalent of Anglo-Saxon EBITDA

– Depreciation and operating provisions

+ Reversals of provisions
+ Other products – Other operating expenses
= Operating profit (EBIT)

+ Financial products – Financial expenses
= Current profit before tax (CBT)

± Exceptional result
– Profits tax
= Net result

We will detail the precise calculation of each SIG, with examples and formulas, in a later chapter devoted to financial analysis.

Income Statement – IFRS Presentation (generic example)

International standards (IFRS, IAS 1) favor a presentation by function rather than by nature. The goal is to provide a more concise and comparable overview between companies in different countries.

Here is a generic example of a Statement of Profit or Loss and Other Comprehensive Income:

STATEMENT OF INCOME for the year ended //____

Operating income (Revenue) =
Turnover (Revenue from contracts with customers)
+ Other operating income

Operating expenses =

Cost of sales
+ Selling expenses
+ Administrative expenses
+ Research and development costs (if significant)
+ Other operating expenses

→ Revenue – Operating Expenses = Operating Profit (EBIT)

Financial elements:

Financial products
– Financial charges (including interest)

→ EBIT – Financial result = Profit before tax

Income tax (Income tax expense)

→ Net result for the period (Profit for the period)

Other comprehensive income: exchange differences, gains/losses on financial instruments, etc.

→ Total comprehensive income

Important note: From 2027 (IFRS 18, phased in), the structure will become even more standardized with mandatory categories (Operating, Investing, Financing). For now, the presentation remains fairly flexible, but the "by function" principle prevails.

Visual comparison of approaches

Why do these two approaches coexist?

• PCG + SIG: very detailed, oriented towards internal and tax management (France, Belgium, etc.).
• IFRS: more concise, investor-oriented and international comparison (listed groups, foreign companies).

In practice, many French companies produce both: the legal PCG profit and loss statement for filing with the registry, and an analytical version (SIG or IFRS-like) for management and bankers.

Net Result and Balance Sheet

The "final" net result will be recorded as a liability on a company's balance sheet..

If it is positive, it will positively "feed" the company's resources, and then it will be necessary to decide what to do with this money (carryover, reserves, dividends, etc.).

If it is negative, it will decrease the amount of equity, with the possibility that this equity may become negative in the event of losses exceeding the amounts available in equity, and the negative sum of equity on a balance sheet is the financial translation of the losses incurred by the company.

Conclusion

The profit and loss statement is the main document that you need to know how to read when you are a business leader, a decision-maker, a manager or a buyer, because it is this document that allows us to know if the business model of the company is viable, year after year.

Most laypeople only inquire about turnover and rent, vaguely about personnel costs, without analyzing the profit and loss statement in detail, which is a serious mistake.

Now that we have understood how to prepare and read an income statement, we will discover in the next chapter what the balance sheet consists of, and we will see in the next lessons what indicators can be derived from the income statement, in order to estimate the financial health of a company and especially its profitability for the year concerned by the income statement.

Feel free to subscribe to the blog and comment, and I'll see you soon for the next chapter.

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