The income statement

The income statement (also called the profit and loss account, or P&L) answers one question: did the business make money over this period? It is the first statement most people read, and the one on which bonuses, share prices and lending decisions often hinge.

Its layout tells a story. Each line strips away one kind of cost, so you can see where profit is made or lost: in the product itself, in running the business, in financing it, or in tax.

When things are recorded. The income statement follows accrual accounting: revenue is recorded when the goods or service are delivered, and an expense is recorded in the period it helps earn that revenue. A cake delivered to a hotel on 30 December belongs to this year's revenue even if the hotel pays in February. Flour bought in bulk sits in inventory and only becomes cost of goods sold when the bread made from it is sold. A machine expected to last five years is not charged in full in the year it is bought; its cost is spread over those years as depreciation.

This matching is what makes profit a fair measure of performance. Without it, a month in which a business happened to buy a year's supply of packaging would look disastrous, and the following eleven months would look brilliant. The price of that fairness is that profit and cash drift apart, which is why the cash flow statement exists (two lessons on).

A method you can use on any P&L: (1) start from revenue; (2) subtract the direct cost of what was sold to get gross profit; (3) subtract running costs, including depreciation, to get operating profit; (4) subtract interest to get profit before tax; (5) apply the tax rate to that line; (6) what remains is net income. Then divide each profit line by revenue.

Reading margins like an analyst. Each margin points to a different lever. A gross margin that slips while sales hold up usually means input costs rose or prices were cut, a question about the product and its pricing. An operating margin that falls while the gross margin is steady points to overheads growing faster than sales: more staff, higher rent, heavier marketing. A gap between operating and net margin is about financing and tax: a heavily borrowed business can run its shops well and still keep little for its owners.

A single margin on its own says little. Compare it with the same company's earlier years, and with competitors in the same industry: a supermarket and a software company have very different normal margins, and neither is "better". The comparison tells you where to dig, for example whether the bakery should renegotiate ingredient prices or look at its overheads.