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Analyzing an income statement is an important process undertaken by investors and management alike to determine the financial health of a specific company. One way to accomplish this is to compare the current statement against statements from a company's recent past, thereby spotting any potential trends. Another good method of analyzing an income statement is achieved by using financial ratios, which are gathered through the data on an income statement and are excellent tools for comparing companies in similar industries. Anyone who studies an income statement should understand the basic relationship between revenue and expenses that leads to a company's net income.
Most companies that have to answer to shareholders are responsible for preparing financial statements. Chief among these is the income statement, also known sometimes as the profit and loss statement. This document essentially shows how much money a company has earned over a period of time when factoring in all of the money spent in the process of making products or offering services. Analyzing an income statement can reveal whether or not a company is currently on sound financial footing.
The basic equation that should be understood when analyzing an income statement states that expenses subtracted from revenue equals net income. Revenue comes from the sales that are made during the time period being studied. Expenses come from different sources, including cost of goods sold, operational expenses, taxes, and interest owed. All of these items are listed on the statement, with the net income being the ultimate result of the company's business operations for that specific period of time.
Since all of these items are included on a statement every year, analyzing an income statement for a company can be done by comparing all of these past statements with the current one. Doing this can help management spot trends that are developing within the company. It can also show areas where the company is being efficient and, by contrast, areas where there might be waste that is weighing down the bottom line.
Financial ratios are another excellent tool to be used when analyzing an income statement. Earnings per share, which is calculated by dividing a company's earnings by its current number of outstanding shares of stock, is an example of a financial ratio. This ratio, and all others that are formed by comparing two bits of financial data, can be used to compare a company to its competitors. Identifying benchmarks, which are companies operating at the top of an industry, and seeing how the company being studied compares to these benchmark firms is an excellent way to use financial ratios in income statement analysis.