What is a 3-Statements Model? Step-by-Step Explanation

1. What is an Income Statement?

The Income Statement is one of the three primary financial statements (Balance Sheet & Cash Flow Statement are the other two). It reports:

• Revenues (Sales)
• Expenses
• Gains/Losses
• Net Profit/Loss

for an accounting period (quarterly, annually, or even monthly for internal financial reporting). It is often referred to as the "P&L" because it begins with profit (sales) then subtracts losses (expenses) to show net income, the much sought after “bottom line.”

1. Types of Income Statements

There are 4 types of income statements.

• Single-Step Income Statement. This income statement presents revenues and expenses in broader classes. It is easy to read because it is simple without much detail. Example: Used very commonly by small businesses and start-ups.
• Multi-Step Income Statement. This income statement provides the distinction between operating versus non-operating. It also allows identifying gross profit, operating income, and net income. This is useful for medium to large companies, especially public companies.
• Common Size Income Statement. This income statement shows every line item as a % of revenue. This is useful to compare between industries or peers.
• Pro Forma Income Statement. This is both forward looking, assumed and projected. Most typically used in financial modelling, M&A and fundraising contexts.

2. Structure and Format of the Income Statement

While the detail and terminology can vary depending on the nature of the business, a multi-step income statement typically will include the following headings:

• Revenue (or Sales) - Total cash received.
• Cost of Goods Sold (COGS) - Direct cost of production/service.
• Gross Profit = Revenue - COGS.
• Operating Expenses (OPEX) - SG&A, R&D, marketing, depreciation.
• Operating Income (EBIT) = Gross Profit - OPEX.
• Other Income/Expenses - Non-core operations (interest, forex, asset sales).
• Earnings Before Tax (EBT).
• Taxes.
• Net Income (Profit/Loss) - the bottom line.

This format not only shows how profit is earned, but where it is consumed and held.

3. Detailed Line-by-Line Breakdown

• 1. Revenue: Can be considered operating revenue (basic sale of the business) or non-operating revenue (interest from bank, royalties). For example, you can like bank interest income vs. subscription payments of a SaaS company.
• 2. Cost of Goods Sold COGS: Raw materials, labor, other direct cost of production. Consultants salaries might be under the COGS heading for services firms.
• 3. Gross Profit: Indicator of production efficiency. High gross margin shows pricing power; low gross margins can indicate competition.
• 4. Operating Expenses OPEX: SG&A: Salaries, rent, utilities, advertising etc. R&D: As you might imagine, particularly large in the tech and pharma segments. Depreciation & Amortization: Non-cash charges.
• 5. Operating Income (EBIT): This is "core profitability"; thus, it excludes financing and non-core items. Typically, this is what is compared between companies to measure the overall operational strength.
• 6. Other Income/Expenses: (Gains/losses from the sale of assets, interest income, influence of foreign exchange etc.). Not part of core operation.
• 7. Earnings Before Tax (EBT): After interest but before tax.
• 8. Taxes: Corporate income tax, by jurisdiction. Deferred tax items might exist.
• 9. Net Income: The leftover after deducting everything. Distributions to shareholders as dividends or profit retained in the business.

4. Sample Income Statement with Example

Particulars (in ₹ Lakhs) Amount
Revenue 10,000
Less: COGS 6,000
Gross Profit 4,000
Less: Operating Expenses 1,200
Operating Income (EBIT) 2,800
Less: Interest Expense 300
Earnings Before Tax 2,500
Less: Taxes 750
Net Income 1,750

5. Key Ratios Derived from the Income Statement

These ratios make the income statement decision-useful.

• Gross Margin = Gross profit ÷ revenue
• Operating Margin = EBIT ÷ revenue
• Net profit margin = Net income ÷ revenue
• EBITDA Margin = EBITDA ÷ revenue
• Interest Coverage Ratio = EBIT ÷ Interest Expense

Industry Examples:

• Technology companies (e.g. Microsoft, Google): have high gross margins but also high R&D.
• Manufacturers (e.g. Tesla, Tata Steel): have high COGS but lower operating margins.
• Retailers (e.g. Walmart, Reliance Retail): have thin margins, but high volume.
• Startups: typically, net losses – due to marketing expenses and R&D.

Case Study - Apple Inc. (2023 Annual Report)

Apple reported: Revenue: $383B; Gross Profit: $170B; Net Income: $97B. Take-away: The gross margin of 44% indicates pricing power; the net profit margin of 25% indicates efficiency, profitability, and remaining profitable in a highly competitive global economy.

6. Common Misunderstandings and Limitations of the Income Statement

• 1. Not Accounting For Non-Cash Items – depreciation is non-cash flow.
• 2. Overvaluing Net Income – EBITDA and cash must be considered more relevant metrics.
• 3. Not Adjusting for One-Time Items – litigation, sale of an asset, and restructuring.
• 4. Not Taking Account of Industry – a 10% margin is great in retail and awful in software.

Income Statement Compared to Other Financial Statements:

• Balance Sheet – a point in time of assets, liabilities, and equity.
• Cash Flow Statement – actual cash in and out.
• Income Statement – performance over a period.

They make up the holy grail of financial reporting.

Income Statement Limitations:

• Estimates & Assumptions (e.g., bad debt allowance, depreciation).
• Non-Cash Items can affect actual liquidity.
• No Overall Financial Condition – needs balance sheet and cash flow.
• Earnings Manipulation – the company can manipulate the accounting to improve their earnings position.

7. Final Thoughts on the Income Statement

The Income Statement is more than a compliance document—it's a narrative of profitability and performance. While it may be a report to an investor, entrepreneur, or student, the income statement can give you the ability to:

• Assess the ability to operate in a profitable state.
• Solicit potential risks and opportunities.
• Foretell possible future performance.
• Make informed investment or business decisions.

In summary, the income statement is not just a collection of numbers, it's also about the story behind the numbers.

8. Getting to Know the Cash Flow Statement: The Lifeblood of Financial Reporting

No matter the size or industry, money is the fuel for every business. Of course, the words revenue and profits often prevail in those conversations, but it is cash that measures whether a company can pay its bills, make payroll, add staff, grow operations, or simply survive. One company could make financial profits on paper—and then fail for lack of cash.

This is where the Cash Flow Statement comes in. Sometimes called the Statement of Cash Flows, it provides insight into how cash flows into and out of the company over the course of a period. The Cash Flow Statement is unique in that it measures only cash inflows and outflows over the period, whereas the Income Statement measures profitability of the company and the Balance Sheet describes the financial position of the company at a fixed point in time. The Cash Flow Statement measures: How much actual cash the business generated and used during the period? The Cash Flow Statement is often called just that—it is the lifeblood of financial reporting—because it conveys how a business's cash flows all examples of what cash cannot measure. It quickly removes accounting adjustments from a reporting period and identifies on a statement basis of just cash—the liquidity position of a business.

Why is the Balance Sheet Important?

Importantly, the Balance Sheet means something far more than compliance; it is about choosing direction and strategy for management and stakeholders aligned to achieving the organization's Purpose.

• For Management - Liquidity management, capital structure decisions, investment or resource allocation decisions, and risk management.
• For Investors - Solvency, growth capacity and direction and overall return on equity over time.
• For Creditors - The Capacity and Capability of the organization to pay its debts as they come due.
• For Analysts - Information to inform ratio analysis and benchmarking.
• For Regulators - Transparency, governance and statutory requirements.

Ultimately, the absence of a Balance Sheet means the stakeholders are blind in their understanding of the business's over leveraged, under capitalized or financially solvent position.

Balance Sheet Types

• Classified Balance Sheet: Classifies assets and liabilities as current and non-current. The most common format used by companies.
• Common Size Balance Sheet: Presents each line item as a percentage of total assets. Useful for comparing against peers or within an industry.
• Comparative Balance Sheet: Presents balance sheets from different time periods side by side. Good for looking at trends and growth.
• Consolidated Balance Sheet: Consolidates the financial position of both the parent company and it's subsidiaries as a single entity.

Structure and Format of the Balance Sheet

A typical balance sheet has:

• 1. Assets: Assets are resources controlled by an entity that are expected to provide economic benefits in the future. Current Assets (Resources that are expected to be converted to cash or consumed within 12 months): Cash & Cash Equivalents, Accounts Receivable, Inventory, Prepaid Expenses. Non-Current Assets (Long term resources): Property Plant & Equipment (PPE), Intangible Assets (Trademarks, Goodwill), Long Term Investments, Deferred Tax Assets.
• 2. Liabilities: Liabilities are the obligations that the company has to pay off. Current Liabilities (will be due in 12 months): Accounts Payable, Short Term Debt, Accrued Expenses, Current Portion of Long-Term Debt. Non-Current Liabilities (will be due in more than 12 months): Long Term Loans, Bonds Payable, Pension Liabilities, Lease Liability.
• 3. Shareholders' Equity: Equity represents the owners' claim after deducting the liabilities. Share Capital, Retained Earnings, Reserves & Surplus, Treasury Stock (has been repurchased by the company and is taken out of equity.) Equity = Assets – Liabilities.

Example Balance Sheet (XYZ Ltd.)

(₹ in Lakhs)
Assets
Current Assets:
Cash: 2,500
Accounts Receivable: 3,000
Inventory: 4,000
Non-Current Assets:
PPE: 7,500
Intangibles: 1,000
Total Assets: 18,000

Liabilities
Current Liabilities:
Accounts Payable: 2,200
Short-Term Debt: 1,800
Non-Current Liabilities:
Long-Term Debt: 5,000
Total Liabilities: 9,000

Equity
Share Capital: 5,000
Retained Earnings: 4,000
Total Equity: 9,000
Total Liabilities + Equity: 18,000

Key Ratios Derived from Balance Sheet and Industry-Specific Features

These ratios are useful for the purpose of assessing liquidity, solvency and operating efficiency.

• Current Ratio = Current Assets ÷ Current Liabilities
• Quick Ratio = (Current Assets - Inventory) ÷ Current Liabilities
• Debt-to-Equity Ratio = Total Debt ÷ Equity
• Return on Equity (ROE) = Net Income ÷ Equity
• Asset Turnover = Revenue ÷ Total Assets

Industry-Specific Features for Balance Sheets:

• Banks/Financial Institutions: A company's loan book will be sizeable with deposits as liabilities.
• Tech Firms: Larger amounts of intangibles (patents, software, goodwill).
• Manufacturing: Typically, large investments in plant and inventory.
• Retailers: These firms will have a higher current asset structure and on average, greater inventories.
• Start-ups: Will often show heavy liabilities (venture debt) or negative retained earnings.

Case Study – Tesla, Inc. (2023 Balance Sheet Highlights): Total Assets - ~$107B; Total Liabilities - ~$37B; Total Equity - ~$70B. A few insights include: Tesla's relatively high equity position reflects retained earnings accumulating as operations grew and success led to several capital raises. Non-current assets (factories and Gigafactories) reflect major long-term growth investments. The low amount of leverage relative to many traditional automakers of similar size clearly reflects operational soundness in the business.

Common Misinterpretations and Limitations of the Balance Sheet

Common Misinterpretations:

• Intangibles May be Overvalued: Goodwill and/or patents may not hold any real resale value.
• Neglecting Off-Balance Sheet Items: Such as operating leases or commitments for minimum future payments, may not appear directly on the balance sheet.
• Assuming All Assets = Liquid: Inventory may not convert to cash very quickly from previous experience!
• Misunderstanding Leverage: It is possible that a substantial debt load may be sustainable in capital-heavy industries but risky in a tech-startup scenario.

Balance Sheet VS Other Financials:

• Income Statement: Profitability (flow of time).
• Cash Flow Statement: Liquidity and cash flow.
• Balance Sheet: Financial position (point in time).

Combined give you a full picture of financial health.

Limitations:

• Historical Value: assets could be recorded at cost instead of being recorded at their current market values.
• Estimates & Judgments: depreciation, provision for bad debts or estimates with any other financial input can lead to distortions.
• Non-Financial Factors not included: brand strength, employee skillsets, ESG impact.
• Window Dressing: companies will initiate transactions in time with the reporting periods in order to make a balance sheet appear stronger.