A income statement follows a descending logical order. Each line reveals a part of the company’s value creation process. Understanding what each one means and how it relates to others is essential to correctly interpret the profitability of the business.
1. Operating income (net sales)
They are the income that comes from the main business of the business, presented net of discounts, returns and taxes. Here the story begins: how much is your company selling for its normal operation? It is worth checking if these incomes grow or stagnate, if they depend on few customers, if growth has its origin in price or quantity, and if there are marked seasonalities. A healthy business not only sells a lot: it does so sustainably.
2. Cost of Sales (COGS)
Also called the cost of the merchandise sold, it represents the direct value of the goods or services delivered in the sale of a period: what it cost him to produce or acquire what he finally sold. Understanding it well is vital, because it determines the gross margin and reveals how efficient your value generation process is. It’s not just about selling more, but about selling better.
- Direct raw material: materials that are incorporated directly into the final product.
- Direct labor: the cost of personnel directly involved in the manufacture or execution of the service.
- Indirect manufacturing costs (CIF): energy, maintenance, depreciation, supervision, lease of the production area, among others.
In the services, the cost of sales may also include specialized software, talent subcontracting, or licenses necessary to deliver value to the customer.
3. Gross margin
It shows how much is available to cover operating expenses after covering the costs of what is sold:
Gross Margin = Income − Cost of Sales
High-volume and low-price-based business models typically operate with low gross margins, which requires rigorous control of spending and impeccable execution. With such tight margins, any deviation in operating costs or poorly calibrated financial decisions can quickly erode profit.
‘The cost advantage is only sustainable if the company is able to strictly control each component of its cost structure.’ — Michael Porter, Competitive Strategy (1980)
4. Operating expenses (OPEX)
Also known as Operational Expenditures, they represent the disbursements necessary for the business to function on a day-to-day basis, without being directly related to the cost of what is sold: administrative personnel, sales, marketing, advertising, leases, technology, public services, insurance and consulting, among others.
There is a golden rule that every entrepreneur should consider: In healthy business, operating expenses should grow at a lower rate than sales. If your sales grew 8% and your operating expenses only 6%, you are gaining efficiency.
‘Don’t save what’s left after you spend, spend what’s left after you save.’ — Warren Buffett
An aspect that should not be overlooked: Loading the company personal expenses or unjustified consumption distorts the true performance of the business. Keeping a clean and disciplined accounting is a sign of professionalism and responsibility with financial information.
5. Operating income (EBIT)
It is the result that remains after subtracting the operating expenses from the gross margin. Indicates whether the business model is sustainable and profitable at its core, regardless of debt or taxes. If EBIT is solid and consistent over time, the business operating heart is working well. Whether it is weak or volatile—even with positive net income—it is worth asking whether that profitability actually comes from the operation or from transitory elements.
6. Other income and expenses
Here income or expenses are recorded, non-recurring or non-operating, such as the sale of assets, compensation, donations or fines. They are lines that can distort the result if they are not analyzed carefully.
7. Financial expenses
They reflect the interest and other costs associated with the use of debt. Not all debt is bad: there is the so-called “smart indebtedness”, the one that finances projects with a clear, measurable return and greater than the cost of financing. However, borrowing should never be impulsive. Before assuming a financial obligation, it is appropriate to evaluate:
- What will the money be used for?
- What is the expected return of the project or activity?
- Can the quotas be assumed without affecting the operation?
- Does the benefit exceed the total financial cost?
If the expected return is less than the cost of debt, the business is destroying value.
8. Income Tax
It is the tax on net income. It varies according to the country’s tax regime and the applicable deductions. An entrepreneur must understand how it is calculated and how you can legally optimize it.
9. Net income
It is the final result of the income statement: what the company actually won or lost after all costs, expenses, interest and taxes. Although it is a key fact, it should not be analyzed alone: it is necessary to review how solid that utility was, if it was generated operationally or by extraordinary events, and how it compares with previous periods.
Clarus Council: The gross margin tells you if your business produces well; EBIT tells you if you walk alone; The net profit tells you how much was left at the end. Analyzing them separately is the only way to know which link is the opportunity for improvement.
At Clarus Consultores we break down each line of its income statement to identify in which link in the chain it is losing profitability.. Let’s talk of the structure of your P&L