Income statements usually known as Profit & Loss Statements consist of various heads of operating as well as non-operating incomes and expenses for specified period e.g. quarter ended 20xx or Financial year ended 20xx etc. The format of the income Statement is exhibited below –
Starting with top-line (generally referred to as sales/incomes/revenues etc.). Adjusting top line with respect to related costs and expenses whether direct or indirect (whether recurring or non-recurring), we arrive at pre-tax income. Finally deducting the tax expense (generally referred to as Corporate Tax as per statutory norms) from pre-tax income we arrive at the bottom line (generally referred to as Net profit/Net Earning/Net Income etc.). In this article, we are going to elaborate on major components of the Income statement with respect to operating as well as non-operating income and expenses.
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To recognize the operating income of a company, there is a need to understand the business fundamental of that company. It is the income that a company’s earnings/losses from its core operations of their business.
For example, Ashok Leyland company is in the business of manufacturing vehicles i.e. Trucks, Busses, light vehicles, Services & Sale of spare parts for their core products (i.e. vehicles they manufacture), etc. Incomes generation from these major heads after deducting related direct and indirect costs are treated as operating income.
Operating Income Formula
Where Operating expenses are the cost of Selling, general and administrative expenses; other misc. operating expenses etc. Operating Expenses is discussed in detail below:
Operating Income also be known as EBIT (Earnings before Interest and Taxes) as well as can also be referred to as EBITDA (i.e. the cash operating profit before adjustments of Depreciation & Amortisation).
Operating Income is used to evaluate the earning performance of the company horizontally (for analyzing its historical trends) as well as vertical (for comparison among other companies in a peer group). The major earnings performance metrics are EBIT margin % & EBITDA margin %.
For valuation purposes operating earrings/income is also a useful tool for comparison purposes among other companies in the peer groups. The major multiples are used in terms of valuation are – EV/EBITDA; EV/EBIT etc.
The expenses which are beyond the nature of “Cost of Goods Sold” i.e. “manufacturing cost”; “carriage inward costs”; “cost of raw materials”; “Inventory management costs”; “trading costs”; “Packaging costs” etc are termed as Operating expenses. Such expenses are generally classified under “Selling expenses”; “General and Administrative Expenses”; “Research and Development expenses”; “Depreciation and Amortisation” etc. are termed as Operating Expenses.
Apart from that, there are other expenses, which are not classified under the above-mentioned heads of operating expenses, which are classified as “other operating expenses”.
The examples of operating expenses are –
Salaries and commission to salespersons; payroll taxes and other benefits; Advertising and Promotional activities; other departmental administration costs, etc.
General & Administrative Expenses
Salaries or wages of Administrative staff; Rental expenses; Insurance expenses; office supplies and subscriptions expenses; consultancy services (for financial services, legal services, business promotional services, etc); Depreciation and Amortisation on Office Equipment’s, etc.
Other Operating Expenses
Any other expenses which are operating in nature but not under the purview of the above-mentioned operating expenses are generally referred to as overhead expenses. These expenses are not directly chargeable to revenues or classified under COGS e.g. outsourcing costs; operating leases expense; maintenance-related expenses; bank and postal charges etc.
Research and Development expenses
R&D expenses are usually incurred by the company even the outcome of the research has not been put into an account for generating revenues. Research and Development expenses are either integrated with Selling General & Administrative expenses or reported separately.
Apart from core components of Income statements, there are some other line items generally referred to as –
In Income statements, there is another head of income which are not directly related to the core operations of an entity or day-to-day operations of the company. These incomes are generally on an incidental basis i.e. on a non-recurring basis. These heads generally referred to earnings from other sources e.g.
- Interest/Dividend Income;
- Gain from sale/disposal of assets (financial or non-financial);
- Gain from derivative instruments for hedging purposes;
- Gain from the translation of foreign currency transactions; etc.
There are certain expenses incurred outside the course of regular day-to-day operations which are classified as Non-Operating Expenses. Such expenses are generally incurred on an incidental basis and on a non-recurring basis. The respective heads generally referred to non-operating expenses are –
- Interest expenses & other financing costs;
- One-time unusual expenses like restructuring cost, litigation cost, payment towards contingent liabilities;
- Loss from sale/disposal of assets (financial or non-financial);
- Impairment loss;
- Loss from derivative instruments for hedging purposes;
- Loss from the translation of foreign currency transactions; etc.
Impacts of Non-operating Income & Expenses in the bottom line of the Income Statement
Non-operating incomes & expenses both can affect the bottom line of an income statement either positively or negatively based on the amount of Income or Expense. For example, non-operating revenue may artificially increase profit margins whereas expenses reduce it. Hence to nullify these impacts, there is an exclusion of non-operating income and expenses from income statements with respect to the most common accounting approach. This helps Analysts to portray a more accurate picture of the operating efficiencies of the business/company.
Income statement analysis determines a company’s earnings performance and also provides outlook potentials with respect to its historical trends, providing an insight into how the company conducts its business in the past.
It is important to bifurcate the company earnings based on their core operating business model. For this, we have to eliminate the non-operating incomes/expense (as reported above the line items viz. EBIT and EBITDA) to arrive at core operating EBITDA/EBIT (generally referred to as Adjusted EBITDA or Adjusted EBIT for financial analysis). There are various adjustments towards the same:
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To arrive at Adjusted EBIT:
Adjusted EBIT = Reported EBIT – Reported non-operating incomes and expenses (if any reported above EBIT).
Similarly, to arrive at Adjusted EBITDA:
Adjusted EBITDA = Adjusted EBIT + Depreciation & Amortisation.