Income statements | IGCSE Class 10 Business Studies Notes

This note covers what profit means and how a business makes it, why profit matters to private sector businesses, the difference between profit and cash, the main features of an income statement (revenue, cost of sales, gross profit, profit and retained profit), and how simple income statements are used in business decision-making.

What is profit and how is it made?

Profit is the surplus left over when a business's total revenue (the money earned from selling goods or services) is greater than its total costs for the period. If costs are greater than revenue, the business makes a loss instead.

Definition: profit. Profit is revenue minus expenses for a trading period; a positive figure means revenue exceeded costs, a negative figure (a loss) means costs exceeded revenue.

A business makes profit mainly by selling its output for more than it costs to produce and sell it.

It earns revenue from sales, pays out cost of sales (the cost of the goods it has sold) and other running expenses, and keeps whatever remains.

This remaining amount rewards the owner for the money, time and risk they have put into the business.

How does profit build up from revenue?

Profit is not the same thing every time it is measured. A business can calculate several different types of profit from the same set of figures, starting from gross profit and working down to the final profit for the period, and in the case of a company, to retained profit.

Each stage removes a further category of cost. Revenue is reduced first by the cost of the goods actually sold, to give gross profit; gross profit is then adjusted for other running costs and other income, to give profit; and profit is finally reduced by any dividend paid to shareholders, to give retained profit.

A student reading an income statement should be able to point to each of these stages and explain what has been deducted to move from one figure to the next, because an examiner may ask for any one of the stages separately rather than only the final profit figure.

Why is profit important to private sector businesses?

Profit matters to privately owned businesses for two linked reasons.

Reward for risk-taking

Profit is the reward for risk-taking and enterprise. An owner who starts and runs a business risks their own money, time and reputation; the business might fail.

Profit compensates the owner for taking that risk, and it is the main reason many people set up and continue to run a private sector business rather than working for someone else.

Source of finance

Profit is also a source of finance for the business. Profit that is not paid out to the owner (or to shareholders, in the case of a company) can be kept inside the business and used to buy new equipment, open new premises, develop new products or pay off debt, without the business having to borrow or raise new capital from outside.

This internally generated finance is usually cheaper and easier to arrange than a bank loan or a new share issue.

Without the prospect of profit, most owners would have little incentive to keep investing their money and effort in a private sector business.

These two reasons, reward for risk and a source of finance, are the two points an answer on the importance of profit needs to cover, each explained rather than simply stated.

What is the difference between profit and cash?

Profit and cash are not the same thing, and a common mistake is to assume that a profitable business always has plenty of cash in the bank.

Profit is an accounting measure: it is calculated by matching the revenue earned in a period against the costs incurred in earning it, even if some of that revenue has not yet been received as cash and some of those costs have not yet been paid in cash.

Cash is simply the money the business actually holds or can draw on at a given moment.

Why does the gap between profit and cash arise?

A business can be profitable on its income statement yet short of cash. This can happen if a large part of its sales are made on credit, so the revenue is recorded before the cash is collected from customers, or if the business has spent cash buying stock, new machinery or other fixed assets that have not yet turned into sales.

A business can also hold plenty of cash while reporting a loss, for example if the cash comes from a new bank loan or extra capital put in by the owner rather than from trading.

Because of this gap, a business needs to monitor its cash position separately from its profit, since a shortage of cash (rather than a shortage of profit) is one of the most common reasons a business fails.

An owner who only checks the profit figure, without also checking how much cash customers owe and how much cash is tied up in stock, can be caught out by this difference.

What are the main features of an income statement?

An income statement is a financial statement that shows how a business's profit (or loss) for a trading period has been arrived at. It is built up in stages from revenue down to the final profit figure.

Definition: income statement. An income statement is a financial statement, prepared for a trading period, that shows revenue, cost of sales, gross profit, expenses and the profit (or loss) earned by the business.

Its main features are:

1. Revenue: the total value of sales made by the business in the period, before any costs are deducted.
2. Cost of sales: the cost to the business of the goods it has actually sold in the period, generally made up of opening stock plus purchases and direct expenses, less closing stock.
3. Gross profit: revenue less cost of sales; it shows the profit made purely from buying/making and selling goods, before other running expenses are taken into account.
4. Profit (sometimes called net profit): gross profit plus any other income, less all remaining expenses of running the business, such as rent, salaries, advertising and bad debts.
5. Retained profit: the part of the profit that is kept in the business rather than paid out to the owner or shareholders.

These figures appear in a set order, each one feeding into the next, so that a reader can see exactly how the final profit figure has been built up from revenue.

Which costs belong in cost of sales, and which are expenses?

A business preparing an income statement has to decide where each cost it has paid out should go, because this affects both gross profit and profit. Costs fall into two broad groups.

Direct costs are costs connected with getting the goods themselves ready for sale: the purchase price of the goods, carriage inwards (the cost of transporting goods bought in), factory wages paid to workers directly making or handling the goods, and similar costs needed before a sale can happen.

These are included inside cost of sales, together with opening and closing stock, so they are deducted before gross profit is reached.

Indirect costs (often simply called expenses) are the other running costs of the business that are not tied to a specific unit of goods: rent of premises, salaries of office or administrative staff, advertising, bad debts and interest paid are typical examples.

These are deducted after gross profit, on the way to profit, rather than being part of cost of sales.

Getting this split right matters for decision-making. If a direct cost is wrongly treated as an indirect expense, gross profit will look too high and profit will be unchanged; if an indirect expense is wrongly bundled into cost of sales, gross profit will look too low even though the business's final profit is unaffected.

A manager comparing gross profit between two years, or between two similar businesses, needs the split to be made consistently, otherwise the comparison is misleading.

Does every business lay out its income statement the same way?

A sole trader or a partnership can usually lay out its own income statement, choosing its own order and headings for expenses, as long as revenue, cost of sales, gross profit, expenses and profit are all shown clearly.

A limited company does not always have this same freedom. Company law generally sets out a required format and order for the figures a company must present in its published accounts, so that shareholders, banks and other outside readers can compare one company's statement with another's more easily. This is a stricter requirement than the free layout a sole trader may choose.

This matters for the main features listed above because it shows that the basic features of an income statement, revenue, cost of sales, gross profit, expenses and profit, are common to every business, but the exact layout a particular business must follow can depend on whether it is legally required to use a standard format, such as a limited company, or whether it is free to choose its own layout, such as a sole trader.

How do revenue and cost of sales determine gross profit?

Gross profit is the first and most basic profit figure in an income statement. It isolates the result of a business's core trading activity, buying or making goods and selling them, before any other running costs are included.

Definition: gross profit. Gross profit is revenue less cost of sales; it measures the profit earned purely from trading in goods, before other expenses are deducted.

Gross Profit = Revenue − Cost of Sales

Cost of sales is itself built up from several figures: the value of opening stock held at the start of the period, plus purchases made during the period and any direct expenses needed to get goods ready for sale (such as carriage inwards or factory wages), less the value of closing stock still unsold at the end of the period.

Cost of Sales = Opening Inventory + Purchases + Direct Expenses − Closing Inventory

Worked example 1. A business has revenue of $125,000 for the year. Its purchases for the year were $75,000 and direct expenses (wages on the goods purchased) were $8,000. There was no opening or closing stock.

Answer: Cost of sales = $75,000 + $8,000 = $83,000. Gross Profit = Revenue − Cost of Sales = $125,000 − $83,000 = $42,000.

Worked example 2. A business has revenue of $2,000,000. Opening stock was $300,000, purchases were $1,500,000, direct expenses (freight inwards and wages) were $200,000 in total, and closing stock was $400,000.

Answer: Cost of sales = $300,000 + $1,500,000 + $200,000 − $400,000 = $1,600,000. Gross Profit = $2,000,000 − $1,600,000 = $400,000.

If cost of sales is higher than revenue, the result is a gross loss rather than a gross profit; this would be unusual for a business selling at normal prices and suggests its pricing or buying costs need urgent review.

How are profit and retained profit calculated?

Gross profit on its own does not show the full picture, because it ignores the other running costs of the business, such as rent, salaries, advertising, bad debts and interest, and any other income the business earns besides sales, such as commission received or interest received.

Profit = Gross Profit + Other Income − Expenses

Worked example 3. A business has a gross profit of $57,000 for the year. It also received commission of $5,000. Its other expenses for the year were salaries $25,000, rent of building $13,000 and bad debts $4,500 (total $42,500).

Answer: Profit = Gross Profit + Other Income − Expenses = $57,000 + $5,000 − $42,500 = $19,500.

For a company, part of this profit is usually paid out to its shareholders as a dividend, and the part that is kept in the business is called retained profit.

Definition: retained profit. Retained profit is the share of a company's profit that is kept within the business after any dividend has been paid to shareholders, available to reinvest or build up reserves.

Retained Profit = Profit − Dividends

Worked example 4. A company's income statement shows a profit for the year of $19,500. The directors decide to pay a dividend of $6,000 to shareholders.

Answer: Retained Profit = Profit − Dividends = $19,500 − $6,000 = $13,500. The board should keep this $13,500 inside the business, for example to fund future growth, rather than distribute it, since the aim is to reinvest.

What can a company do with retained profit?

Retained profit sits between the profit figure and the shareholders' pockets: it is the part of profit a company chooses not to distribute, so that it can be reinvested in new equipment, premises or product development instead of being paid out straight away.

A business that retains more profit in good years builds up a cushion it can draw on if a future year's trading is weaker, without needing to borrow or raise fresh capital from outside investors.

A board of directors deciding how much dividend to pay must balance two competing interests: shareholders generally want a dividend now, while the business itself may need the money retained to grow.

A company that pays out almost all of its profit as dividends keeps shareholders satisfied in the short term but has little retained profit to finance expansion; a company that retains most of its profit can grow faster but may see some shareholders look for a higher dividend elsewhere.

How are income statements used in decision-making based on profit calculations?

Owners, managers and other stakeholders read an income statement to answer practical questions about the business, using the profit figures it reports.

Three simple calculations help turn these absolute figures into a basis for comparison between periods, or between businesses of different sizes, rather than comparing dollar amounts alone, which is harder to judge fairly when sales volumes differ.

How are profit margin, gross profit margin and mark-up calculated?

Expressing profit as a percentage of revenue shows how much of every dollar of sales ends up as profit after every cost has been covered.

Profit Margin = Profit ÷ Revenue × 100

Using the figures in the table above, Profit Margin = $50,000 ÷ $500,000 × 100 = 10%. A decision-maker can compare this percentage with an earlier period or with a similar business, since it strips out the effect of a business simply being larger or smaller.

A second calculation looks only at the trading stage, before other running expenses are deducted, and expresses gross profit as a percentage of revenue.

Gross Profit Margin = Gross Profit ÷ Revenue × 100

Using the same figures, Gross Profit Margin = $200,000 ÷ $500,000 × 100 = 40%.

Comparing this with Profit Margin of 10% in the same table shows that a large share of the business's gross profit (40% of revenue) is being absorbed by its other running expenses before profit is reached, which is itself a useful signal for a manager deciding where to cut costs.

A third calculation compares gross profit with cost of sales, to check whether goods are being sold at an adequate price above what they cost the business.

Mark-up = Gross Profit ÷ Cost of Sales × 100

Using the table figures, Mark-up = $200,000 ÷ $300,000 × 100 = 66.7%, meaning gross profit is roughly two-thirds of what the goods cost to buy or make.

A manager comparing this period's figures with an earlier period's can judge whether the business is improving.

A low or falling gross profit margin suggests the business should review its buying prices or its selling prices; a falling mark-up points to the same problem from the cost side.

A profit margin that is positive but falling, with expenses rising faster than revenue, can suggest where costs should be cut.

Who else reads income statement figures, and why?

A bank or prospective investor reading the income statement can use the profit figures as one guide (alongside other information) to whether the business looks able to repay a loan or reward new investment.

An owner deciding whether to expand, take on a partner, or close down a loss-making product line will look first at whether revenue is covering cost of sales and expenses, and whether profit is being made consistently rather than in one unusual year.

Advantages of using income statements in decision-making

• They show, in one place, how revenue, cost of sales, gross profit, expenses and profit relate to each other, so a decision-maker does not have to search for separate figures.
• Comparing several periods' income statements, or the profit margin calculated from them, shows a trend in profit, which is more reliable for decisions than looking at a single year on its own.
• Gross profit margin, mark-up and profit margin can be compared with other businesses of a similar size, helping an owner judge whether their own costs or pricing are competitive.
• Because the layout is standard, outside stakeholders such as banks, suppliers and prospective owners can read and compare income statements quickly.

Limitations of income statements for decision-making

• An income statement is based on past trading, so it does not guarantee that the same profit will be made in future periods.
• Profit figures do not show cash position, so a business can look profitable on its income statement while actually running short of cash.
• The figures can be affected by choices made in preparing the accounts, such as how stock is valued, which makes comparing two different businesses' profits less straightforward.
• An income statement says nothing about non-financial matters, such as staff morale, customer satisfaction or the quality of the product, which also affect how well a business is really doing.

Going beyond the syllabus

Larger businesses often also calculate an operating profit, the profit made from normal trading activities before interest and tax are deducted, so that unusual or purely financial items do not distort the view of day-to-day performance.

Operating profit is found by taking the profit figure and adjusting it back for any non-operating items:

Operating Profit = Net Profit + Non-operating Expenses − Non-operating Incomes

Non-operating expenses are purely financial costs, such as interest paid, while non-operating incomes are items such as interest received; abnormal, one-off items, such as a loss caused by a fire, are also left out of this calculation.

Operating profit sits conceptually between gross profit and profit in the sequence of profit figures, since it strips out financial and unusual items that do not come from the everyday buying and selling activity of the business, giving a clearer picture of how the core operations are performing from one period to the next.

This is a useful extension once the basic gross profit, profit and retained profit figures are understood, although constructing a full income statement with a separate operating profit line is not required at this level.

Glossary

• Revenue: the total value of sales made by a business in a trading period, before any costs are deducted.
• Cost of sales: the cost to the business of the goods it has actually sold in the period.
• Gross profit: revenue less cost of sales, showing the profit from core trading activity alone.
• Profit: gross profit plus other income, less all remaining expenses, for a trading period.
• Retained profit: the part of a company's profit kept in the business rather than paid out as a dividend.
• Dividend: a payment made from a company's profit to its shareholders.
• Cash: the money a business actually holds or can draw on at a given moment, as distinct from profit.
• Income statement: a financial statement showing how a business's profit for a period has been arrived at.
• Opening inventory (stock): the value of unsold goods held at the start of the trading period.
• Closing inventory (stock): the value of unsold goods held at the end of the trading period.
• Direct expenses: costs directly connected with getting purchased goods ready for sale, such as carriage inwards.
• Source of finance: a means by which a business obtains money to fund its activities, such as retained profit.
• Risk-taking: the owner's exposure to the possibility of financial loss in starting and running a business.
• Sole trader: a business owned and run by one person, who keeps all the profit and bears all the risk.
• Private sector: businesses owned and run by individuals or companies rather than by the government.

Common errors and misconceptions

• Misconception: a profitable business always has plenty of cash. Correct: profit and cash are different; credit sales and spending on stock or assets can leave a profitable business short of cash.
• Misconception: gross profit and profit are the same figure. Correct: gross profit is revenue less cost of sales only, while profit also deducts other running expenses and adds other income.
• Misconception: cost of sales is the same as total expenses. Correct: cost of sales covers only the goods actually sold; other running expenses such as rent and salaries are deducted later to find profit.
• Misconception: retained profit is the whole of the year's profit. Correct: retained profit is only the part kept in the business after dividends (or the owner's drawings) have been paid out.
• Misconception: a loss means the business has no cash at all. Correct: a business can report a loss on its income statement while still holding cash, for example from a loan or new capital.
• Misconception: an income statement on its own proves a business will keep making the same profit. Correct: it shows past performance; future profit depends on factors the statement cannot guarantee.
• Misconception: all unsold goods at the year end are an expense. Correct: closing stock is deducted when calculating cost of sales, because it has not yet been sold.

Exam-style questions with model answers

Q1. State two reasons why profit is important to a private sector business. [2 marks]

1. Profit rewards the owner for the risk and effort of starting and running the business, compensating them for the chance that the business could fail.
2. Retained profit provides a source of finance that lets the business invest in new equipment or premises without having to borrow from a bank.

Q2. A business has revenue of $240,000 and cost of sales of $150,000. Calculate its gross profit, showing the formula you use. [2 marks]

1. Gross Profit = Revenue − Cost of Sales = $240,000 − $150,000 = $90,000, which is the profit earned from the core trading activity alone, before other expenses are deducted.

Q3. Explain why cost of sales must be calculated before gross profit can be found. [3 marks]

1. Gross profit is found by taking cost of sales away from revenue, so cost of sales has to exist as a figure before that subtraction can be made.
2. Cost of sales itself has to be built up first, from opening stock, purchases and direct expenses, less closing stock, before it can be used.
3. Without an accurate cost of sales figure, the gross profit calculated afterwards would not correctly show how much the business gained purely from trading in goods.

Q4. Distinguish between gross profit and profit (net profit) in an income statement. [4 marks]

1. Gross profit is revenue less cost of sales only, so it measures the result of the core trading activity before any other costs are taken into account.
2. Profit, by contrast, starts from gross profit and adds any other income, such as commission received, and deducts all remaining running expenses, such as rent, salaries and bad debts.
3. Gross profit therefore always appears before profit in an income statement, since profit is calculated from it.
4. A business could have a healthy gross profit yet a low profit (or even a loss) if its other running expenses are very high.

Q5. Explain the difference between profit and cash, using an example. [5 marks]

1. Profit is an accounting measure, found by matching revenue earned against costs incurred in a period, whether or not the money has actually changed hands.
2. Cash is the actual money the business holds or can access at a given time, such as in its bank account.
3. For example, a business making most of its sales on credit records the revenue as soon as the sale is made, but does not receive the cash until the customer pays later.
4. As a result, the business can show a healthy profit on its income statement while having little cash available to pay suppliers or wages.
5. A business can also hold plenty of cash while reporting a loss, for example if the cash comes from a new loan rather than from trading.

Q6. A company's income statement shows a profit for the year of $84,000. The directors decide to pay a dividend of $30,000 to shareholders. (a) Calculate the retained profit. (b) Explain two ways the business could use this retained profit. [5 marks]

1. (a) Retained Profit = Profit − Dividends = $84,000 − $30,000 = $54,000.
2. (b) The business could use this $54,000 to buy new equipment or open new premises, since retained profit is money kept inside the business rather than paid out, and using it this way avoids the cost and risk of borrowing from a bank or raising new capital from outside investors.
3. Alternatively, the directors could choose to build up reserves with this retained profit, giving the company a cushion to draw on if trading conditions become more difficult in future.
4. Retaining rather than distributing profit also lets existing shareholders keep full ownership of the business, since no new shares need to be issued to raise finance this way.

Q7. A sole trader's income statement shows revenue $650,000, cost of sales $420,000 and expenses of $160,000. (a) Calculate the gross profit. (b) Calculate the profit. (c) Explain one way the owner could use this information to make a business decision. [6 marks]

1. (a) Gross Profit = Revenue − Cost of Sales = $650,000 − $420,000 = $230,000.
2. (b) Profit = Gross Profit − Expenses = $230,000 − $160,000 = $70,000.
3. (c) The owner can compare this gross profit with earlier years or with similar businesses to judge whether buying or selling prices need to change.
4. If profit has fallen compared with a previous period, the owner may decide to review and cut certain expenses rather than raise prices, to protect the business's overall profit.
5. Conversely, if both gross profit and profit are strong and growing, the owner may decide this is a good time to use retained profit to expand the business.

Q8. Evaluate whether a business owner should rely only on this year's profit figure to decide whether to expand the business, given that revenue is $400,000, cost of sales is $250,000, profit is $90,000, but cash at bank has fallen by $20,000 during the year. [6 marks]

1. The profit figure of $90,000 (after cost of sales of $250,000 and other expenses) looks encouraging and suggests the core trading activity is sound.
2. However, the fall in cash at bank of $20,000 shows that healthy profit has not translated into healthy cash in this period.
3. This gap could be caused by money tied up in unsold stock, by customers who have not yet paid for credit sales, or by spending on new equipment.
4. If the owner expands using only profit as evidence, the business could run short of cash to pay suppliers, wages or loan repayments during the expansion.
5. The owner should therefore also check cash flow forecasts and the bank balance, not just the profit figure, before committing to expansion.
6. Overall, profit is a useful but incomplete guide; it should be read alongside cash information before making a major decision such as expansion.

Key takeaways

• Profit is revenue minus costs for a period, and it rewards owners for the risk they take in running a private sector business.
• Retained profit is an important source of finance, letting a business grow without borrowing or raising new capital externally.
• Profit and cash are different; a profitable business can still run short of cash, especially where sales are made on credit.
• An income statement builds up profit in stages: revenue, then cost of sales, then gross profit, then profit, then retained profit for companies.
• Gross profit measures only the result of core trading; profit also includes other income and deducts remaining running expenses.
• Cost of sales is usually opening stock plus purchases and direct expenses, less closing stock.
• Decision-makers use income statement figures to compare periods, judge pricing and costs, and decide on actions such as expanding or cutting expenses.
• Income statements have limitations: they report the past, ignore cash position, and say nothing about non-financial performance.

Test yourself

What two things can profit be used to reward or fund in a private sector business?

Profit rewards the owner for risk-taking, and retained profit provides a source of finance for the business to grow.

Why can a profitable business still run short of cash?

Because profit includes revenue not yet collected as cash, for example from credit sales, or because cash has been spent on stock or fixed assets.

What is the formula for gross profit?

Gross Profit = Revenue − Cost of Sales.

What four items usually make up cost of sales?

Opening stock, purchases, direct expenses, and closing stock, which is subtracted at the end.

How does profit differ from gross profit?

Profit starts from gross profit, adds any other income, and deducts all remaining running expenses of the business.

What is retained profit, and who does it apply to?

Retained profit is the part of a company's profit kept in the business after any dividend to shareholders is paid.

Give one limitation of using an income statement for decision-making.

It reports past trading and does not show cash position, so future performance and liquidity are not guaranteed.