There are four major types of financial statements used to evaluate the economic conditions of a company. These include cash flow statements, statements of shareholder's equity, balance sheets and income statements. Of these, the balance sheet and income statement are most common and represent the most important financial information about the company. While the balance sheet--which shows assets and liabilities--represents the company's finances at one particular moment, the income statement, also called a profit and loss sheet, gives a picture of the company's income and expenses over time. This makes it a great tool for evaluating the company's health.
The use of income statements in their current form ties in with the Industrial Revolution of the 19th century. During this time, business was booming in the U.S., and to fuel that growth, companies were taking out large bank loans to build factories and purchase equipment. To qualify for these loans, they were required to provide their sales and expenses, as well as gross profit. The income statement, which shows revenue, expenses and profit vertically from top to bottom, naturally evolved out of this process. At the same time, managerial accounting, in which company directors use financial data to decide how to run the company, was growing in popularity. To equip managers and banks with the information they needed in an easy-to-read fashion, our current form of income statement, called a "vertical income statement," became widely accepted as the standard format.
The purpose of the income statement is to give investors or banks a clear overview of the company's financial health, including revenue generated (typically over a 3-year periord), expenses incurred and the difference between these two figures, known as net profit. These numbers help creditors evaluate the company's performance and financial health while determining credit worthiness. They also provide a good base for estimating future cash flow, especially when the past year's results are compared to one another.
Because it is completed in such a standard format, the income statement is readily identifiable and recognizable. It starts with income at the top--made up of sales revenue, interest earned, cash and other income sources. The second section is comprised of expenses, including cost of goods sold, rent, payroll and any other expenses incurred as a result of doing business. At the bottom of the statement, these two figures are added together to provide a net profit or loss, also known as "the bottom line."
There are four major types of income statement. The first is those completed for businesses. They are almost always in the standard format and are prepared by an accounting professional. The second type is those created for individuals. This is useful for the self-employed or those looking to start a business, who may be required to provide an income statement before taking a loan. Another variety is the consolidated income statement, used by companies that are made up of several different brands of groups. The consolidated statement shows the financial picture for the entire company, not just a particular branch. Finally, there are those used by non-profit groups. Here, income is replaced by funding sources, and expenses are replaced by administrative and operating fees. Though not an income statement per se, it serves the same purpose.
While income statements are useful tools, they do have their limitations. First, there are many items that are impossible to capture but provide a large amount of benefit or worth, including brand recognition and goodwill generated by the company. Second, numbers on these reports can be skewed depending on the method of accounting used by the company. Finally, there can be discrepancies due to the evaluation of estimates, including those for depreciation of the current value of assets.