Businesses keep track of their financial information in a variety of ways and for a number of different reasons. The multi-step income statement is a variation of one of the key financial documents that businesses utilize.
A company’s management team, as well as its investors and potential creditors, need certain financial data about the company to make sure it is performing well. They can get this data through official records of the company’s finances – namely income statements, balance sheets and cash flow statements – that provide key information during a particular reporting period.
When it comes to income statements, which are also called “profit and loss” statements (P&L Statements), there are two main formats a business can use to provide key financial metrics to others and to keep records for its own use in improving the company. One income statement format is called “single-step,” which has one equation to derive net income. The other is “multi-step,” which uses several equations to derive income.
In this article, you’ll learn more about the differences between the two income statement types, and dive into more detail on how multi-step income statements are created.
First, though, let’s review the main features of an income statement and why these financial documents are important to investors and company executives.
The importance of income statements
Income statements are essentially how businesses report their losses and gains. They provide a picture of what money came into and out of a business during a certain time period. In other words, income statements detail a company’s profitability that results from revenue and expenses.
Other common key financial statements include 1.) the balance sheet, which provides information on the company’s assets and liabilities, and 2.) the cash flow statement, which details changes in how money flows through the company, including by changes in the balance sheet.
Typically, income statements cover a quarter of a year, or three months’ worth of activity. They can also cover a full year with an annual income statement or any other specified time period.
How the multi-step income statement helps investors
A company’s income statement provides critical information about profitability for investors making decisions on which securities to buy.
Comparing a company’s profitability on its income statement from quarter to quarter or year to year can help investors get a sense of how a company is performing. Analyzing these numbers can reveal trends that investors may want to understand to help them predict how the company will perform in the future.
Aside answering whether and by how much a company is profitable, an income statement can also help show investors how the company can translate its expenses into profits.
Finally, investors can compare metrics on an income statement against the company’s peers to understand its role in the industry, including whether its profitability is more competitive or less competitive than others.
Key features on an income statement
There is no one specific structure that an income statement must follow. Instead, each company drafts its income statement in a slightly different way and with different company-specific numbers.
However, income statements do tend to share some common main features. Among these are revenue, expenses, gross income and net income.
Revenue is the total amount of money a company brings in during a certain reporting period. Many companies earn money by selling goods or services, so the term “revenue” is sometimes used interchangeably with “sales.” Companies can also earn revenue from interest on investments or from fees or royalties.
Revenue is one of the most important numbers to illustrate a company’s health because the company’s revenue is what keeps it competitive and growing. Growing revenue is a key part of growing profits. So, knowing a company’s revenue, and how it compares to its competitor’s revenue, helps investors and company executives understand its viability.
Expenses are the costs a company must pay to operate its business. Basically, they are items that account for money going out of a company. Some examples of expenditures include the cost of goods sold, direct labor costs or material costs. Every item that requires a business to pay money instead of receiving it is considered a cost.
Expenses are an important number to know about a business because it shows how much it costs to operate it. If expenses are growing, an investor may expect that profitability could shrink. Companies managing expenses well are looked on more favorably because they have the potential to be more profitable.
Gross income (*for multi-step income statements)
Gross income is the initial income figure you get when you subtract the Cost of Goods Sold (COGS) from the total sales. Gross income, a simple measure of a company’s productivity, doesn’t reflect the fact that the company may face other costs, aside from COGS.
Gross income shows the health of the company’s core business. With higher gross profit, a company is in a better position to achieve higher net income. It’s critical to analyzing a company’s profitability because it reveals a basic understanding of whether the company actually made money or not.
Net Income / Loss
Net income is the money that a business has earned after it has added in all positive and negative non-operating items. Mainly, this net income is the number you get after you have subtracted all expenses, Cost of Goods Sold (COGS) and interest, as well as taxes and any loss from depreciation of assets. (In contrast, again, gross income is a result of only subtracting the cost of goods sold, not costs like rent or utilities.)
Net income, a “bottom line” number, allows helps investors or company executives understand a company’s profitability so they can better project future profitability or, in the case of company management, make changes to improve profitability.
Multi-step income statement vs. single step income statement
Generally, larger corporations and companies use multi-step income statements because their operations are more complex, and people want a more in-depth understanding of what is working within the business.
Publicly traded companies, in particular, use multi-step income statements because they’re legally required to disclose more details about their earnings with regular financial reports.
Smaller businesses like sole proprietorships tend to use the more straightforward single step income statements, which are easier and less time-consuming to prepare.
In some cases, small businesses may turn to multi-step income statements if, for example, they are trying to raise investment funds or get a bank loan. The advantage of single step income statements is they provide a simple income figure, which allows investors to quickly see at a glance how the business is fairing.
The main difference between a multi-step income statement and a single-step income statement is that the multi-step income statements provides more detail.
Multi-step income statements break down income and expenses as well as profits and losses into operating items and non-operating items, which are those that aren’t directly related to the business practices. Non-operating items include those like revenue or expenses from investments or money earned or paid as a result of lawsuits. Single step income statements don’t include this step of separating operating items from non-operating items.
With the multi-step approach, businesses use a variety of equations to determine the bottom line “income,” showing different income results along the way to net income. The four steps to calculate how profitable a business include: gross income, operating income, pretax income and net income (after tax).
In contrast, the single step income statement does not include gross income and operating income. It only includes pretax and net (after tax) income. Using this method, you would subtract a company’s cost of materials and product from sales to get the net income. Managers would use this snapshot number to, for example, help set budget goals.
Various formulas in the multi-step income statement
Multi-step income statements use three equations to provide a picture of a company’s income through gross profit, net income and operating income.
- Gross Profit = Total (Net) Sales – Cost of Goods Sold (COGS)
- Operating Income = Gross Profit – Operating Expenses
- Net Income = Operating Income + Non-Operating Items
Essentially, the final net income factors in non-operating items, whether they are revenue or losses, like money from lawsuits or interest on investments. However, investors can see the step-by-step process that yielded that number. They can more clearly see a company’s overall gross profit and operating income without the non-operating items as separate items in the income statement with this multi-step process.
Separating the income out into different categories like this allows investors, creditors and the company’s management to see how different aspects of the business are performing, namely how the core business is functioning without including factors that don’t usually pertain to it.
Example of a multi-step income statement
While each company will have unique figures on their income reports, depending on their exact revenue and expenses, multi-step income statements do follow a similar formula.
Below is a very basic example of what a multi-step income statement may look like for a fictitious company called “Example Corp.”
In the above example, the company has reported gross profit of $350,000 and net income of $308,000. Investors or creditors can review in more detail how the specific line items affect the company’s income in different ways, so the income statement becomes more meaningful to helping them make decisions.
Other key financial statements
Companies provide three core financial statements that investors can use to get a better sense of its financial health.
Aside from income statements, the fundamental statements companies use to shed light on how it is performing also include cash flow and balance sheet statements.
Cash Flow Statements
Public companies are required to report cash flow statements along with its quarterly financial reporting. Cash flow statements detail how cash moves within a company and comes in and out of a company. They show where money is coming from and how it is being used. Changes in both the income statements and balance sheets help determine cash flow figures. Within cash flow statements, the main points companies detail are cash from operating activities, cash from investing activities and cash from financing activities. Sometimes companies also report noncash activities in their cash flow statements.
Investors use cash flow statements to see how well a company is managing its cash and whether it is financially sound. These statements can provide excellent clues to how well the company will fair in the short-term. Companies that are struggling with their cash management could be at risk for not paying their bills. Companies with good cash flow are better able to pay down their debt and keep their operations running.
Balance Sheet Statements
Balance sheets provide a sort of simple snapshot of how the company is fairing at a particular moment in time. (In contrast, income and cash flow statements examine changes.) Balance sheets list assets such as property, investments or cash holdings and liabilities such as debt. They also include how much investors have put into the company, or shareholder equity. A company’s assets, or what it owns, should equal its liabilities plus shareholder equity. For example, if a company’s shareholder equity is $10 million, it should also have $10 million in assets as cash from those investments.
The information on a balance sheet is important for a number of reasons. It helps investors get a sense of its basic capital structure with fundamental analysis. Its numbers can help investors calculate key financial ratios.
The bottom line
Both multi-step and single step income statements have a key role in providing critical information to investors about a company’s financial situations.
Single step income statements are indeed more simple for companies to create and they are easier for investors to understand. The downside is that single-step income statements may not offer investors the ability to analyze the company’s income in a more complex way.
On the other hand, multi-step income statements may be more involved, but they can help paint a clear picture of a company’s income by providing different perspectives.
Namely, the multi-step income statement can better highlight a company’s operating income, which is considered the most important to its business. Accountants can use multi-step income statements to ensure the company is on track to meet its goals, while investors can use this information to determine whether or not to include these companies in their portfolio holdings.
In this way, income statements play a valuable role in providing critical financial information for analysis.