Understanding the difference between net income and profit before tax

Net income and profit before tax, which often appear when reading financial statements, may seem similar but are actually different concepts. Both are indicators of a company's profitability, but their calculation methods and meanings differ.

• Profit before taxis the value obtained by subtracting cost of goods sold, selling and administrative expenses, and non-operating income from revenue and then adding non-operating expenses and corporate tax expense. In other words, it refers to the profit before taxes are paid.
• Net incomeis the value obtained by subtracting corporate tax expense from profit before tax, which represents the final profit left after a company pays all its expenses.

Therefore, by comparing the two indicators, we can understand the level of a company's tax burden and the size of its actual profit. If profit before tax is high but net income is low, it means the tax burden is significant. Conversely, if net income is high but profit before tax is low, it can be seen as a result of significant non-operating expenses or tax benefits.

Assessing health through analysis of key financial ratios

When analyzing an income statement, using key financial ratios can provide a more objective assessment of a company's financial condition. Some typical financial ratios include the following:

• Profitability ratios: These indicators represent how efficiently a company generates profits. Typical profitability ratios include return on assets (ROA), return on equity (ROE), and operating profit margin. These indicators can be used to evaluate a company's profitability and compare it to competitors.
• Solvency ratios: These indicators represent a company's financial stability. Typical solvency ratios include the debt ratio, current ratio, and quick ratio. These indicators can be used to evaluate a company's ability to repay debt and assess its risk of short-term default.
• Activity ratios: These indicators represent how efficiently a company uses its assets. Typical activity ratios include inventory turnover ratio and accounts receivable turnover ratio. These indicators can be used to evaluate a company's asset utilization and identify areas for improvement.
• Growth ratios: These indicators represent a company's growth trend. Typical growth ratios include revenue growth rate, operating profit growth rate, and net income growth rate. These indicators can be used to evaluate a company's growth and predict its future prospects.

A comprehensive analysis of these financial ratios can provide a more accurate assessment of a company's financial condition and management performance. This can help in formulating company strategies and making investment decisions.

Methods of Analyzing Changes in the Income Statement

When analyzing an income statement, it is crucial to identify changes. This allows for a more accurate understanding of a company's performance and financial status.

Here are some ways to analyze changes:

• Analysis of revenue changes: This is one of the most important items. Increasing revenue improves a company's profitability and increases its growth potential. Conversely, decreasing revenue weakens a company's profitability and can lead to a crisis. Factors such as seasonality, economic fluctuations, and the emergence of competitors should be considered.
• Analysis of cost changes: This is important alongside revenue and directly affects a company's profitability. Changes in labor costs, material costs, and advertising expenses should be identified and analyzed. This can lead to identifying ways to reduce costs and improve profitability.
• Analysis of changes in non-operating income and expenses: Changes in interest income, interest expenses, and dividend income should be identified. This can help evaluate a company's financial stability and develop funding plans.
• Analysis of changes in corporate tax expense: Corporate tax expense is a key factor in determining a company's final profitability and should be identified. It can be influenced by factors such as tax audits and changes in tax laws.
• Analysis of changes in net income: Finally, it is important to identify changes in net income. This should be analyzed by considering all of the above items. This can be used to evaluate a company's performance and predict its future prospects.

Practice reading and summarizing the income statement through a real-world example

Let's practice reading a real income statement. Below is the income statement of a hypothetical company, Company A, for 2021.

Account title

Amount

Revenue 100,000,000 won

Cost of goods sold 60,000,000 won

Gross profit 40,000,000 won

Selling and administrative expenses 20,000,000 won

Operating income 20,000,000 won

Non-operating income 5,000,000 won

Non-operating expenses 3,000,000 won

Profit before tax 22,000,000 won

Corporate tax expense 4,400,000 won

Net income 17,600,000 won

Here is a brief summary of the above income statement:

-Revenue for 2021 was 100 million won, and cost of goods sold was 60 million won.
-Gross profit was 40 million won (revenue - cost of goods sold).
-Selling and administrative expenses were 20 million won.
-Operating income was 20 million won (gross profit - selling and administrative expenses).
-Non-operating income was 5 million won, and non-operating expenses were 3 million won.
-Profit before tax was 22 million won (operating income + non-operating income - non-operating expenses).
-Corporate tax expense was 4.4 million won, and net income was 17.6 million won (profit before tax - corporate tax expense).

Conclusion

Today, we have learned how to use the income statement to check a company's profitability. The income statement is one of the most important financial statements and is something you should definitely remember and use effectively.