$1,100 million of sales. $150 million of profit. Harbor Coffee, our fictional coffee business, reports both for FY3.
That leaves $950 million to explain. The income statement puts a name and a number on each deduction between sales and profit. Follow $100 of sales through those layers: which cost takes the biggest bite, and how much survives? The answer tells you more about the business than either headline number alone.
Read the heading before the numbers
The three-statement overview separated a year's profit from a year-end balance. Here, start with the income statement's heading: company, currency, scale and period.
For Harbor, the figures are in millions of US dollars for FY3, the third year shown. An entry of 1,100 means $1,100 million for the year. The heading changes the meaning of every number below it.
Consolidated financial statements present the parent company and its included subsidiaries as one group. You are reading the group's results, rather than just the parent's accounts.
Parentheses often mark a negative amount. An expense can also be printed as a positive number and still be subtracted, so read the line label as well as the sign.
From sales to gross profit
Revenue is sales recorded for the period: $1,100 million for Harbor. Cost of revenue is the cost assigned to the goods or services sold. For goods, it is also called cost of goods sold (COGS).
Harbor's cost of revenue is $660 million. Subtract it to get gross profit: $1,100 million − $660 million = $440 million.
That first deduction takes $60 of every $100 in annual sales: 660 ÷ 1,100 × $100 = $60. The remaining $40 has to cover the rest of the expenses and profit.
Harbor supplies no breakdown of the $660 million. Calling all of it "coffee beans" would turn an unknown into a fact.
The waterfall makes the size of this first deduction visible. Solid bars start at zero and mark totals; outlined bars subtract costs. A subtotal is a checkpoint, never another expense.
From gross profit to operating income
Harbor still has to sell the coffee and run the company. Its operating expenses cover those costs beyond cost of revenue. Selling, general and administrative expenses (SG&A) include marketing and office administration.
Harbor lists "Sales & marketing" of $132 million and "General & administrative" of $88 million. Together they make its $220 million "Operating expenses, total."
Subtract that from gross profit: $440 million − $220 million = $220 million of operating income, profit from operations before Harbor's interest and income taxes. Half the gross profit covers these two costs.
Depreciation spreads equipment's cost over the years it is used. Harbor's $40 million "D&A" memo (depreciation and amortization) is already inside the costs above; all of it is depreciation here. Deducting it again would charge the same cost twice.
An expense can reduce profit without a matching cash payment that year; the cash flow statement explains why.
From operating income to net income
Harbor's $20 million interest expense is the year's cost of borrowing. Subtract it from operating income to get pretax income, profit before income taxes: $220 million − $20 million = $200 million.
Harbor has no interest income or other non-operating items. At another company, interest income or gains can lift the result, while losses reduce it. Not every line below operating income is a deduction.
Next comes income tax expense, the tax charge recorded for the period: $50 million under "Income taxes." Tax expense and cash tax payments can fall in different periods.
Subtract that to reach net income, the final accounting profit after expenses and other items: $200 million − $50 million = $150 million.
Paying back a loan's principal reduces debt, not profit. A cash dividend distributes money to shareholders; it is not an expense in this calculation.
Revenue is reported; the profit subtotals below are calculated checks. All amounts match Harbor's FY3 statement, in USD millions.
| Line | Amount | Meaning |
|---|---|---|
| Revenue | 1,100 | Sales |
| Gross profit | 440 | After cost of revenue |
| Operating income | 220 | Before interest and tax |
| Pretax income | 200 | Before tax |
| Net income | 150 | Final profit |
Of each $100 in annual sales, $13.64 reaches net income: $150 million ÷ $1,100 million × $100, rounded to cents. Cost of revenue takes the biggest bite, $660 million, more than all the later deductions combined. You know where most of the sales went; the cost breakdown is the next place to look.
Check the comparison before judging it
The cost labels matter as much as the profit labels. Store labor, rent and depreciation can sit in different categories at different companies. Putting a cost in operating expenses rather than cost of revenue raises gross profit without changing operating income.
Read the accounting notes before treating higher gross profit as evidence of a more efficient business. Moving a cost to a different line does not make it disappear.
On your first pass through a statement, read revenue, operating income and net income. Then find the biggest deduction and what it includes. That gives you a story about the business, instead of a list of profit figures.
Next, examine what grew inside Harbor's revenue. Then profit margins will put these cost layers on a comparable scale.
In short
- Revenue measures sales, before the costs of earning them.
- Gross profit, operating income and net income measure profit after different layers of cost.
- A subtotal is a checkpoint, not another expense to subtract.
- A higher profit subtotal means little until you check the periods and cost categories.
- Net income is an accounting result, not a cash payout.