An income statement (also called a profit and loss, or P&L) answers the most basic business question: did the company make money? It shows revenue, expenses, and profit over a period of time, and reading one is a core Unit 3B skill.
What an Income Statement Shows
An income statement reports a business's financial performance over a period of time — a month, quarter, or year. It starts with the money coming in and subtracts costs step by step until it reaches the profit left over. (Contrast this with a balance sheet, which is a snapshot at a single point in time.)
The Structure, Top to Bottom
Income statements follow a consistent order: Revenue (total sales) minus Cost of Goods Sold (COGS) — the direct cost of making what you sold — gives Gross Profit. Subtract Operating Expenses (rent, salaries, marketing, and other overhead) to get Operating Income. After interest and taxes, you're left with Net Income — the famous “bottom line.”
A Worked Example
Here's a simplified yearly income statement for a small clothing business:
| Revenue | $138,000 |
| Cost of Goods Sold | $46,800 |
| Gross Profit | $91,200 |
| Operating Expenses | $37,200 |
| Pretax Income (no interest expense) | $54,000 |
Why It Matters
The income statement tells owners whether the business is profitable, and where the money goes along the way. Gross profit shows how much is left after making the product; net income shows what's left after everything. Investors, lenders, and managers all read it to judge performance and spot problems — like costs rising faster than sales.
Key Takeaways
- An income statement shows revenue, expenses, and profit over a period of time.
- Revenue − COGS = gross profit; gross profit − operating expenses (and interest/taxes) = net income.
- Net income is the “bottom line” — what's left after all costs.
- It reveals profitability and where money is being spent.
Check Your Understanding: How to Read an Income Statement
Five practice questions on How to Read an Income Statement. Tap an answer to see whether you're right and why each choice is right or wrong.
1. Wick & Willow Candles reported these numbers for the last quarter:
Revenue: $60,000
Cost of goods sold: $22,000
Operating expenses: $18,000
What was its gross profit?
Answer: B. Gross profit = revenue − cost of goods sold = $60,000 − $22,000 = $38,000. Operating expenses are subtracted on the next line, not this one.
Why the other choices are wrong:
- A. $20,000 subtracts both COGS and operating expenses ($60,000 − $22,000 − $18,000). That goes past gross profit to operating income.
- C. $42,000 subtracts operating expenses ($60,000 − $18,000) instead of cost of goods sold, which is the direct cost of the candles that were sold.
- D. $60,000 is total revenue. Gross profit still subtracts the cost of goods sold, so it can't be the same as total sales.
2. Fernway Outfitters' income statement for the year shows:
Revenue: $250,000
Cost of goods sold: $100,000
Operating expenses: $90,000
Interest: $5,000
Taxes: $11,000
What is Fernway's net income?
Answer: A. Gross profit is $250,000 − $100,000 = $150,000. Operating income is $150,000 − $90,000 = $60,000. Net income is $60,000 − $5,000 − $11,000 = $44,000.
Why the other choices are wrong:
- B. $55,000 subtracts interest but leaves out the $11,000 in taxes. That is income before taxes, not the bottom line.
- C. $60,000 is operating income. Interest and taxes still have to come out before you reach net income.
- D. $150,000 is gross profit. It subtracts only cost of goods sold, not operating expenses, interest, or taxes.
3. Wren owns a small knitting shop. Which of these items from last month would NOT appear on her income statement?
Answer: D. Borrowed money isn't revenue, because Wren didn't earn it by selling anything and must pay it back. The loan shows up on the balance sheet as a liability instead.
Why the other choices are wrong:
- A. Sales to customers are revenue, the first line of the income statement.
- B. Rent is an operating expense, so it is subtracted on the income statement.
- C. Interest is subtracted after operating income on the way to net income, so it does appear.
4. Coastline Surf Shop's income statements show:
Year 1: Revenue $200,000; Gross profit $120,000; Net income $40,000
Year 2: Revenue $250,000; Gross profit $140,000; Net income $30,000
Which conclusion is best supported by the data?
Answer: C. Gross profit rose by $20,000, yet net income fell by $10,000. So the expenses subtracted after gross profit must have grown by $30,000 (from $80,000 to $110,000), outpacing the gain.
Why the other choices are wrong:
- A. Revenue isn't profit. Revenue rose, but net income, the actual profit, fell from $40,000 to $30,000.
- B. Net income dropped but stayed positive at $30,000. A net loss would mean net income below zero.
- D. Gross profit actually rose, from $120,000 to $140,000. The drop in net income came from expenses subtracted after gross profit, not from product costs.
5. Bayside Ceramics wants to raise its gross profit without changing its prices or the number of mugs it sells. Which action would do that?
Answer: A. The clay in each mug is part of cost of goods sold. Lowering COGS while revenue stays the same raises gross profit (revenue − COGS).
Why the other choices are wrong:
- B. Advertising is an operating expense, which is subtracted after gross profit. Cutting it would raise operating income and net income, but not gross profit.
- C. Rent is an operating expense, so it doesn't affect gross profit. Cheaper rent would raise operating income instead.
- D. Interest is subtracted after operating income. A lower rate would raise net income but leave gross profit unchanged.
Keep Studying
Related: Profit vs. Cash Flow, Break-Even Analysis.
These guides are educational explanations written for the AP Business with Personal Finance course.