# The Income Statement

Business I · Accounting I · https://tryals.app/learn/business-i/the-income-statement

## The Income Statement Waterfall

The **income statement** (P&L) measures performance **over time**, unlike the balance sheet's snapshot. It flows as a waterfall from top line to bottom line.

$$\text{Revenue} - \text{COGS} = \text{Gross profit}$$
$$\text{Gross profit} - \text{OPEX} = \text{EBIT}$$
$$\text{EBIT} - \text{Interest} - \text{Tax} = \text{Net profit}$$

**Revenue** is the value of goods or services delivered (accrual basis, not cash). **COGS** is the direct cost to produce them.

**Operating expenses** (OPEX) cover running the business: rent, salaries, and marketing. **EBIT** isolates operational profit before financing and taxes.

| Level | Question it answers |
| --- | --- |
| Gross profit | Does the product make money? |
| EBIT | Does the business model work? |
| Net profit | What remains for owners? |

## Margins and Pitfalls

**Net profit** (the bottom line) is what remains after everything, flowing directly into retained earnings on the balance sheet.

**Margins** turn the waterfall into percentages of revenue:

$$\text{Gross margin} = \frac{\text{Gross profit}}{\text{Revenue}}$$
$$\text{Operating margin} = \frac{EBIT}{\text{Revenue}}$$
$$\text{Net margin} = \frac{\text{Net profit}}{\text{Revenue}}$$

Example: A firm with a 40% gross margin and 5% net margin keeps 40 cents per euro after production, but only 5 cents after all costs.

> **Common pitfall:** Reading net profit as cash earned. Accrual revenue includes unpaid invoices, and expenses include non-cash depreciation. Profitable firms can still die of cash starvation.

## Practice questions

8 of this lesson's 13 practice questions, with answers. The full set is in the app.

### 1. Which items appear on the income statement (not the balance sheet)?

A. Depreciation expense
B. Cost of goods sold
C. Sales revenue
D. Accounts receivable

**Answer:** A. Depreciation expense; B. Cost of goods sold; C. Sales revenue

**Why:** Revenue, depreciation expense, and COGS are income-statement flows. Accounts receivable is a balance-sheet stock, the asset created when revenue is earned on credit.

Page: https://tryals.app/practice/business-i/the-income-statement/which-items-appear-on-the-income-statement-not-the-balance-sheet

### 2. Net profit flows into retained earnings on the balance sheet at period-end.

**Answer:** True

**Why:** The closing entry sweeps net profit into retained earnings, the permanent bridge between the two statements. This is why the balance sheet always reflects cumulative lifetime profit.

Page: https://tryals.app/practice/business-i/the-income-statement/net-profit-flows-into-retained-earnings-on-the-balance-sheet-at

### 3. Order the income-statement waterfall from top to bottom.

**Answer:**

1. Revenue
2. Minus COGS = Gross profit
3. Minus operating expenses = EBIT
4. Minus interest = EBT
5. Minus tax = Net profit

**Why:** Each line peels away a cost layer: production, operations, financing, government. The waterfall is the P&L's visual logic.

Page: https://tryals.app/practice/business-i/the-income-statement/order-the-income-statement-waterfall-from-top-to-bottom

### 4. A firm has revenue 2,000, COGS 1,200, OPEX 500, interest 100, and tax 50. **Estimate the net margin** (net profit / revenue, as %).

**Answer:** 7.5 (within ±0.5)

**Why:** Net profit $= 150$. Net margin $= 150 / 2000 = 7.5\%$. Seven and a half cents of every revenue euro reach the owners, the rest went to materials, people, lenders, and the state.

Page: https://tryals.app/practice/business-i/the-income-statement/a-firm-has-revenue-2-000-cogs-1-200-opex-500-interest-100-and-tax

### 5. Revenue or expense? Sort each item.

**Answer:**

- Revenue: Sales of finished goods, Service fees earned
- Expense: Depreciation of equipment, Marketing and advertising, Electricity for the office

**Why:** Revenue is value delivered to customers. Everything else — production, administration, depreciation, marketing — is cost. The income statement subtracts the second from the first.

Page: https://tryals.app/practice/business-i/the-income-statement/revenue-or-expense-sort-each-item

### 6. Match each profit line to what it measures.

**Answer:**

- Gross profit → Revenue minus the cost of making the product
- EBIT → Profit from operations, before financing and tax
- Net profit → What remains after all costs, interest, and tax
- Gross margin → The share of revenue left after direct costs

**Why:** Three profit lines, one ratio, each peeling back a different cost layer to answer a different question.

Page: https://tryals.app/practice/business-i/the-income-statement/match-each-profit-line-to-what-it-measures

### 7. Analysts often compare firms on EBITDA rather than net profit. What does stripping out interest, tax, depreciation and amortisation buy, and what does it hide?

A. It hides revenue quality, since EBITDA excludes cost of goods sold
B. It buys nothing; EBITDA is simply an easier number to calculate
C. It compares across financing structures and hides capital cost
D. It buys accuracy, since the four excluded items are estimates

**Answer:** C. It compares across financing structures and hides capital cost

**Why:** Removing financing and tax makes two differently-funded firms comparable; removing depreciation pretends the machines last forever. Buffett's objection is exactly this, for a business that must constantly replace its assets, depreciation is a real cost and EBITDA flatters it.

Page: https://tryals.app/practice/business-i/the-income-statement/analysts-often-compare-firms-on-ebitda-rather-than-net-profit-what

### 8. Two firms have identical EBIT of 200, but Firm A has interest expense 80 and Firm B has interest expense 10. Which comparison is fair?

A. Neither can be compared
B. Net profit is fairer because it includes all costs
C. The firm with higher interest is always worse
D. EBIT, which strips out financing differences

**Answer:** D. EBIT, which strips out financing differences

**Why:** EBIT exists precisely for this comparison: it measures operational profit before the financing decision kicks in. Firm A chose more debt, so it pays more interest, but operationally they perform identically.

Page: https://tryals.app/practice/business-i/the-income-statement/two-firms-have-identical-ebit-of-200-but-firm-a-has-interest-expense