When you read a financial statement, there are certain key terms that can be confusing. The most common confusion of terms is income and earnings. Income is found at the top of the income statement (also known as the profit & loss statement) and earnings is found at the bottom. The reason for this is the income statement is a description of the flow of money through an organization. Income is the money coming into the business. Gross margin is the sub-total that results from subtracting the cost of production and sales from income. After subtracting administrative expenses from the gross margin, you get earnings.
Most enterprises derive their income from sales of products and services. Other income can be from interest received on investments, sale of property or subsidiaries and royalty or rental income. The income is produced by selling something that the company either manufactures or buys for resale. Even if the company sells services, the company originates those services. As money flows through the organization, the cost to produce the products being sold is the first important benchmark.
Cost of Sales
Income or revenues from sales must be modified by the cost of producing the products or services that are sold. Cost of goods sold, shown as COGS in some financial reports, includes the cost of production or manufacture, or the cost of buying inventory for resale. It can also include the cost of advertising, sales commissions, patent royalties paid out and anything else that can be considered a cost that is necessary to the sales process. Gross margin is the next important benchmark on the income statement.
Gross margin is what is left of revenues after the cost of goods sold is subtracted. Gross margin is a very useful number because it shows how much money the company makes from its main income-producing activities, and how much is available for administrative and operational expenses. It helps management hone the cost of production to create a greater return available for expanding and operating the company. It also separates the money involved in producing income from the overhead expenses, and makes it easier to see where to cut back overhead and increase earnings -- the next benchmark on the income statement.
After subtracting from gross margin the cost of expanding, operating and administering the company, you are left with EBITDA, or earnings before interest, taxes, depreciation and amortization. This is referred to as earnings, and after the additional expenses are subtracted, you have net earnings or net income. EBITDA shows how much profit the company made after all the expenses of running the company are paid. Income, minus COGS, gives the gross margin. Subtract administrative expenses from gross margin, and you are left with the true earnings of the company -- or losses, if the expenses are too high.
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