The Income Statement: How the Money Is Made

From revenue all the way down to net income

The income statement answers “how much did we make over this period?”: revenue minus cost of goods sold gives gross profit, minus expenses gives operating income, and after interest and taxes what's left is net income.

Two key ratios

gross margin shows whether the product itself makes money; net margin shows how efficient the whole business is. With the same $100 million in revenue, a software company with an 80% gross margin and a supermarket with 20% have completely different business models.

Fixed costs amplify swings in profit

Costs like interest, rent and a research team don't change with revenue. When revenue grows, profit grows faster; when revenue falls, profit falls harder. That's operating leverage.

Key takeaways

• Revenue − cost of goods sold = gross profit; gross profit − operating expenses = operating income; minus interest and taxes = net income.
• Gross margin shows how profitable the product itself is; net margin shows overall efficiency. They vary hugely by industry, so compare with peers.
• Fixed costs like interest and rent amplify swings in profit: when revenue grows, profit grows faster, and when revenue falls, profit falls harder.
• Revenue growth doesn't mean profit growth: if expenses grow faster, profit can actually fall.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Keep the default “Sample company”: out of every $100 in revenue, how much net income is left?
2. Raise interest expense to 2M: operating income is still positive, but what does net income become?
3. Set interest back to 300K and drag revenue from 10M to 20M: is net income exactly twice what it was? Why?
4. Switch to “Software company” and “Supermarket chain”: what are each one's gross margin and net margin?

Quiz and explanations

1. Revenue is $1,000 and gross margin is 40%. What's gross profit?

Answer: $400.$1,000 × 40% = $400.

2. Which of these is NOT on the income statement?

Answer: Cash balance.The cash balance is a snapshot at one moment in time, so it's on the balance sheet.

3. Revenue is $2,000, gross margin 30%, expenses 20% of revenue, interest $50 and the tax rate 25%. What's net income?

Answer: $112.5.Gross profit $600 − expenses $400 = operating income $200; minus interest leaves $150; after 25% tax, $112.5 remains.

Terms in this lesson

• gross margin (Gross Margin): (Revenue − cost of goods sold) ÷ revenue, showing how profitable the product itself is.
• income statement (Income Statement): Revenue, costs, expenses and profit over a period, answering “how much did the company make?”
• net income (Net Income): The profit left after all costs, expenses, interest and taxes.
• net margin (Net Margin): Net income ÷ revenue: how much of each $1 of revenue ends up as profit.
• operating income (Operating Income): Gross profit minus selling, admin and R&D expenses, showing how profitable the core business is.
• operating leverage (Operating Leverage): The higher the share of fixed costs, the more revenue changes swing profit: profit grows faster when revenue rises and falls harder when it drops.
• revenue (Revenue): Total income from selling products and services, the top line of the income statement.