income statement analysis essay

How to Read and Analyze an Income Statement

Heather Liston

7 min. read

Updated November 7, 2023

Ever feel a little left out when people start chatting about P&L’s?  How about when the talk turns to income statements, or profit and loss reports, or even a “statement of activities”? The first bit of good news is that all of these refer to the same thing, so you may not have as much to learn as you thought. The second is that an income statement is based on a  few very simple concepts, which you already understand.

The basic suite of financial statements a company produces, at least annually, consists of the statement of cash flows, the balance sheet (or statement of financial position), and the income statement.

The ones that people most often look at (and most often pretend to understand), are the latter two. The major difference between them is this: the balance sheet is essentially a snapshot, while the income statement is a movie. In other words, the balance sheet shows what you own (assets) and what you owe (liabilities) at a moment in time (most often as of December 31). The income statement shows what happens over a period of time (usually a year): what comes in, what goes out, and what’s left over at the end.

Here is an example of a basic income statement, covering the period of one month:

Revenue (or Gross Income):

• Allowance          $2.00
• Candy               ($1.50)

Net Income:                $ .50

See how that works? The top section lists money coming in during the period, the middle section lists money going out, and the bottom line is the difference between the two. All the math you need to produce or proofread this statement is a little basic subtraction.

Now flip open the annual report of any Fortune 500 company and find the income statement. What you see, in basic concept and structure, will be exactly like the one above. The only difference is that it has a lot more lines.

As companies get larger, they start making a few common variations on the structure. Many, for example, have a section at the top that starts with total revenue, then subtracts “cost of revenue” and shows the difference as “gross profit”.  The “cost of revenue” line is the total of all expenses the company deems to be directly related to generating the revenue, such as the cost of purchasing inventory. From the gross profit, they then subtract normal operating expenses, like administration and research and development, which leads to another sub-total called, usually, “operating income,” or, more jargonistically, EBIT or EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization). From that, obviously, interest and taxes (and maybe depreciation and amortization) have to be subtracted before the statement shows the final net income line.

All the complexity sketched out in the previous paragraph, though, is nothing more than a little rearrangement of the basic elements—income and expenses—into some sub-categories. The same principles still apply, even when things start to look complicated. No matter what, the income statement includes just income, expenses, and differences between the two. And income is always listed before expense in any group; it’s just that some companies do more sub-grouping before they get to the bottom line.

No matter what twists and turns you take along the way, the last number on the income statement is crucial. It is labeled “Net Income” above, but it also goes by names like “surplus,” “the bottom line,” or maybe “contribution to savings.” If the bottom line is a negative number, it will most often be called the “deficit” or “loss.” The math and the meaning are exactly the same; these are purely terminology issues.

If you’re asked to review an income statement and you’re not sure where to start, here are a few things to do:

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• 1. Check all the math

Yes, errors occur even in printed, published statements; even in ones produced by major companies. If you find an error, you look smart—and you might also uncover something that changes the results completely. Also, as you run through the adding and subtracting, you will improve your own understanding of exactly how the numbers fit together.

2. Find the bottom line (Should be easy—it’s at the bottom)

On a very basic level, it’s good to see a positive number there. That means the company earned more than it spent during this period. That means it can pay its employees, keep the lights on, and not be forced to borrow money.  But if that bottom line is preceded by a minus sign, or printed in red, or enclosed in parentheses, then expenses exceeded revenue. Find out why. And what the plan is for making the red turn to black.

A net loss once in a while does not necessarily imply disaster. Sometimes new companies have a lot of start-up costs and do not expect to turn a profit in the first year or three. Or maybe the business in question is a cyclical one, like agriculture: if your company grows corn and there was no rain this year you will likely show a loss.  Perfectly normal; some years are up; some are down. On the other hand, if net losses become a trend, or if the company does not have enough cash to fund its expenses during the down times, there could be a problem.

• 3. Look at the sources of income

Do they make sense for the business? For example, if you’re in the cotton candy business, then sales income from the county fair sounds right. But if one income line is “gifts from friends” that’s probably not sustainable. What about next year when those friends don’t come through again?

Or say you’re reviewing the statements for a museum. Ten percent of their income came from admission fees last year and 90 percent came from ticket sales for a special blockbuster exhibit that came through town. Fine, as long as there will be a new blockbuster exhibit every year. If that was a non-repeatable event, though, you will want to ask questions about whether the revenue model is sustainable.

• 4. Look at the expense categories

Are they logical? For most businesses, you will see salaries and wages, insurance, rent, supplies, interest, and at least a few other things. Is anything missing that you would expect to see?  For example, if the business has a hundred employees and you don’t see rent, or mortgage interest, find out why. Is there an office? If not, why not? If yes, how is it being paid for?

• 5. Now look at the amounts: What are the biggest expenses?

If this is a service business, expect to see a large number for salaries. If it’s a manufacturing business, materials and supplies may logically be a significant total. On the other hand, what if you know the company has only three employees but the salary line is extremely high? Is someone being overpaid? Are there more people working there than you realized? Or what if the president told you the company has been profitable for years but you see high interest expense? Find out why the company is borrowing money, and from whom, and whether they’re paying a reasonable rate.

• 6. Compare year-over-year numbers

Usually, the income statement will have separate column showing the figures for the prior year. If the document doesn’t already show the percentage change in every category, calculate those numbers yourself. Question any significant changes. Like, why is sales income 50 percent lower this year than last? Why is insurance 20 percent lower? Did the entity rack up such a great safety record that the insurer lowered its rates? Maybe. But maybe the reduced insurance number has a negative cause—like one of the policies was canceled and the company is at risk in some way.

• 7. Think about logical relationships between numbers

For example, at most companies these days employee benefits (like health insurance, retirement plan contributions, parking passes) are a significant cost. If the salary line doubled but the benefits number went up by only 10 percent, that should strike you as odd. Is there some reason the new employees do not qualify for benefits? Did the company drop one of its benefit plans?

All these questions may have perfectly reasonable answers, but sorting through them will help you understand what’s going on, and give you confidence that you know what you’re talking about when it comes to income statements.

You do. Revenue minus expenses equals the bottom line. Everything else is details.

Ready to get started? Download our  free Profit and Loss Template  today. 

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Heather C. Liston is a San Francisco-based writer, specializing in financial topics.

Table of Contents

• 2. Find the bottom line (Should be easy—it’s at the bottom)

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How to Read Income Statement: Expert Guide to Financial Analysis

• Banking & Finance
• Bookkeeping
• Business Operations
• Starting a Business

Income statements are an essential financial document for investors and business owners, providing valuable insights into a company’s financial performance over a specified period, usually a quarter or a year. These statements summarize the financial transactions, including revenues, expenses, and net income, allowing you to assess a company’s profitability and overall financial health. By understanding how to read an income statement, you’ll be equipped with the knowledge to make informed decisions about investments and business operations.

A comprehensive analysis of an income statement involves understanding the income statement structure, breaking down expenses, analyzing revenue streams, and evaluating the enterprise’s profitability. Additionally, you will need to comprehend tax obligations, the role of depreciation and amortization, and how to decipher key income statement metrics. Comparing the income statement to other financial statements, like balance sheets and cash flow statements, will give you a holistic perspective on a company’s financial position.

Key Takeaways

• Income statements help investors and business owners assess a company’s financial performance and profitability over a specified period.
• Analyzing an income statement requires understanding its structure, breaking down expenses, and evaluating revenue streams.
• Comparing income statements to other financial statements provides a comprehensive understanding of an organization’s financial health.

Understanding the Income Statement Structure

Components of an income statement.

An income statement, also known as a profit and loss (P&L) statement, provides an overview of a company’s financial performance over a specific reporting period. The primary components of an income statement are revenue , expenses , and net income . It is structured using the following formula: Net Income = (Revenue – Expenses) + Gains – Losses.

• Revenue : This represents the money earned from sales or services provided during the reporting period. It is calculated as net sales , which is the total sales minus any discounts, allowances, or returns.
• Expenses : These are the costs incurred in carrying out business activities. The most important expense is the cost of goods sold (COGS) , which represents the cost of producing or acquiring the goods being sold.
• Gross Profit : This is calculated as Revenue – COGS and represents the profit made after considering the direct costs associated with producing the goods or providing services.
• Operating Income : This is determined by subtracting operating expenses (e.g., salaries, rent, and utilities) from gross profit.
• Net Income : The final figure represents the company’s profit or loss after accounting for non-operating items such as interest expenses, taxes, and extraordinary gains or losses.

The Difference Between Single-Step and Multi-Step

There are two primary formats for presenting an income statement: single-step and multi-step.

Single-Step Income Statement In the single-step format, all revenues and gains are grouped together, and all expenses and losses are grouped together. This approach displays only the final result, making it easier to read and understand. The single-step method uses the following format:

Multi-Step Income Statement The multi-step format offers a more detailed view of a company’s financial performance by dividing the statement into several sections. This results in the calculation of gross profit, operating income, and net income. A typical multi-step income statement structure is:

In summary, understanding the structure of an income statement is vital for evaluating a company’s financial performance. Familiarize yourself with the components, and pay attention to the format used, whether it’s a single-step or multi-step income statement, to make informed decisions about the company’s profitability and financial health.

Analyzing Revenue Streams

Total revenue.

Total revenue is a crucial figure for any business to consider, as it represents the total amount of money generated from the sale of goods or services. In an income statement , this figure is typically displayed at the top section – ensuring it is one of the first things to be noticed.

To analyze total revenue, start by examining the following components:

• Sales Revenue : The primary source of revenue for most businesses, this refers to the income generated from selling products or services.
• Other Revenues : These can include additional sources of income such as rental income, licensing fees, or royalties.

When looking at total revenue, it is essential to consider the period in question as well, such as quarterly or annual data. Comparing these figures over time will reveal any growth or decline in the company’s revenue-generating ability.

Net Sales Analysis

Net sales, a subsection of total revenue, is arrived at by subtracting any returns, allowances, and discounts from the gross sales figure. To conduct a comprehensive net sales analysis, follow these steps:

• Examine Gross Sales : Begin by reviewing the overall amount generated from sales before any deductions are made.
• Identify Deductions : Investigate the amounts subtracted, such as returns, allowances, and discounts offered to customers. These should be itemized and detailed within the income statement.
• Calculate Net Sales : Finally, subtract the total deductions from the gross sales figure to identify the net sales amount.

Comparing net sales across different financial periods reveals insights into the company’s sales performance, efficiency, and customer satisfaction levels. A continuous increase in returns, for instance, may indicate a product quality issue, while a larger volume of discounts may signal the need for a pricing strategy revision.

By carefully examining both total revenue and net sales, readers can gain valuable insights into a company’s financial health. This information, in turn, can guide future business decisions and strategies.

Breaking Down Expenses

When reading an income statement, it’s essential to understand the different types of expenses a company incurs. This section will cover the main categories of expenses: Cost of Goods Sold (COGS) , Operating Expenses , and Non-operating Expenses .

Cost of Goods Sold (COGS)

The Cost of Goods Sold (COGS) represents the direct costs associated with producing the goods or services sold by a company. This includes expenses such as raw materials, labor, and manufacturing overhead. Essentially, COGS demonstrates how much it costs a company to produce its products or services.

Here is a simple table to illustrate the components of COGS:

Operating Expenses

Operating Expenses are the costs a company incurs to run its business operations, excluding production costs. These expenses include Selling, General, and Administrative (SG&A) costs, such as marketing, sales, office rent, utilities expenses, and employee salaries not directly linked to production. They also comprise depreciation and amortization associated with the company’s assets.

To provide better understanding, below is a list of common operating expenses:

• Marketing and Advertising
• Salaries and Wages (not directly tied to production)
• Rent and Utilities
• Office Supplies
• Depreciation and Amortization

Non-operating Expenses

Non-operating Expenses are costs unrelated to a company’s core business operations. They may include interest expense from borrowed funds, one-time expenses such as losses from the sale of assets, and other costs unrelated to the primary business activities of the company.

Here are some examples of non-operating expenses:

• Interest Expense on Debt
• Losses from the Sale of Assets
• Legal Settlements
• Impairment Charges

To summarize, understanding the breakdown of expenses on an income statement is crucial for analyzing a company’s financial health. Grasping the differences between COGS, operating expenses, and non-operating expenses enables you to identify the primary drivers of a company’s profitability and make informed decisions.

Evaluating Profitability

Gross profit margin.

Gross profit margin is the first key element to assess a company’s profitability. It is calculated as gross profit divided by revenue. Gross profit is the difference between the total revenue and the cost of goods sold (COGS). This margin represents the percentage of revenue that a company retains after considering the cost of producing its goods or services.

To compute the gross profit margin, use this formula:

A higher gross profit margin usually indicates better financial health, as it shows that the company can efficiently produce its goods or services and generate a profit.

Operating Income vs. Net Income

Another important aspect of evaluating profitability is comparing operating income with net income . Operating income, also known as operating profit or operating earnings, represents the income generated from the regular business operations, excluding any non-operating income or expenses.

Net income or net profit, on the other hand, is the bottom line of the income statement that considers all revenues and expenses, including financial, operating, and tax expenses. It is essential to understand the difference between operating income and net income to assess how effectively the company is managing its resources and whether it can generate sustainable profitability.

A higher operating income usually implies that the company has effective cost management while a higher net income indicates a better overall financial performance.

Earnings Before Interest and Taxes (EBITDA)

Lastly, Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a widely used financial metric to measure a company’s profitability and ability to generate cash flow from its operations. EBITDA is a non-GAAP measure that removes the impact of financial, accounting, and tax-related elements from net income, providing a more accurate comparison of a company’s operational performance across industries and periods.

To compute EBITDA, add back depreciation, amortization, interest, and taxes to the net income:

A higher EBITDA indicates stronger operational performance and suggests that the company is generating sufficient cash flow to fund its growth and meet its financial obligations. Analyzing EBITDA can help identify trends in a company’s profitability and cash flow generation, making it a useful tool for investors and analysts.

Comprehending Tax Obligations

Income before taxes.

When analyzing an income statement, it’s essential to understand the income before taxes . This figure represents the company’s earnings after expenses, such as production costs and operating expenses, are deducted but before tax expenses are applied. In other words, it is the net income before considering tax obligations.

To calculate income before taxes, follow these steps:

• Begin with the gross revenue (or total sales) for the specific period
• Subtract the cost of goods sold (COGS) to obtain the gross profit
• Deduct operating expenses, which include items like rent, salaries, and utilities
• Remove any other non-operating expenses and gains, such as interest or investment income

Tax Expenses

Once the income before taxes is determined, the next step is to consider the tax expenses . This value is the company’s tax obligation on the income earned during the specified period.

Calculating tax expenses involves applying the current applicable tax rate to the income before taxes. Tax rates may vary depending on the company’s jurisdiction, size, and other factors. Keep in mind that tax regulations and rates change over time, so always reference up-to-date information.

By comprehending both income before taxes and tax expenses, you can gain a clear understanding of a company’s financial performance and its tax obligations. Remember to consistently monitor changes in tax regulations, as they may impact your analysis in the future.

Understanding the Role of Depreciation and Amortization

In this section, we will discuss the importance of depreciation and amortization in an income statement and how they impact the financial health of a business. Both depreciation and amortization affect the value of a company’s assets, with depreciation relating to tangible assets and amortization focusing on intangible assets.

Asset Depreciation

Depreciation is an accounting method that allows companies to allocate the cost of tangible assets, such as machinery, vehicles, and equipment, over their useful life. As these assets are used in the company’s operations, their value reduces over time, reflecting the wear and tear or obsolescence. The depreciation expense is recorded on the income statement, reducing the company’s taxable income and providing a more accurate representation of the business’s financial performance.

The most common methods for calculating depreciation are:

• Straight-line method : This method allocates the cost of the asset evenly over its useful life. To calculate annual depreciation, divide the initial cost of the asset by its useful life (in years).
• Double declining balance method : This method accelerates depreciation, resulting in higher depreciation expense in the early years of an asset’s life. It involves applying double the straight-line rate to the remaining asset value each year.
• Units of production method : This method ties the depreciation expense to the actual usage of the asset, such as the number of units produced or the miles driven.

Amortization of Intangibles

Amortization is a similar concept, applied to intangible assets like patents, copyrights, trademarks, or software. These assets do not have a physical form but contribute to a company’s value and revenue-generating potential. As intangible assets are used in the business, their value diminishes over time, which is reflected in the income statement through amortization expenses.

The process of amortization is usually done using the straight-line method, wherein the cost of the intangible asset is divided by its useful life, resulting in an annual amortization expense.

To recap, both depreciation and amortization play an essential role in assessing the financial performance of a company as they allow for a more accurate representation of the value of its assets. By allocating the cost of tangible and intangible assets over their useful life, these methods help provide a clearer picture of the company’s financial health and allow for informed decision-making for stakeholders.

Deciphering Income Statement Metrics

Key ratios and indicators.

When analyzing an income statement, it is essential to examine key financial ratios and performance indicators. These help provide insight into a company’s financial performance, trends, and stability over time. A few important ratios and indicators include:

• Gross Profit Margin : (Revenue - Cost of Goods Sold) / Revenue . This ratio displays the percentage of revenue left after accounting for the direct costs associated with producing goods or providing services.
• Operating Profit Margin : (Operating Income / Revenue) . This ratio indicates how much of the revenue remains after factoring in all operating expenses, excluding interest and taxes.
• Net Profit Margin : (Net Income / Revenue) . This indicator demonstrates the overall profitability of a company, taking into account all expenses, including interest and taxes.
• Earnings per Share (EPS) : (Net Income - Preferred Dividends) / Weighted Average of Common Shares . This metric demonstrates a company’s profitability on a per-share basis.

Profit and Loss Trends

An essential aspect of reading an income statement is identifying any trends regarding a company’s profits and losses. Comparing revenue, operating income, and net income across multiple periods can highlight potential issues or positive developments within a company’s financial performance. Look for the following trends:

• Increases in revenue : A growing top-line could signal the company’s ability to produce products or services that the market demands and its effectiveness in acquiring customers.
• Improvements in gross and operating profit margins : If the company can consistently achieve higher profit margins, it could indicate strong operational efficiency and cost control.
• Divergence between operating and net income : A significant difference between operating income and net income could suggest that the company is carrying a heavy interest or tax burden, which may impact overall profitability.

Financial Health Indicators

Analyzing an income statement also involves reviewing several metrics related to a company’s financial health. These indicators help assess a company’s ability to generate consistent cash flow and manage its debt obligations. Consider the following financial health metrics:

• Cash Flow from Operating Activities : This metric, obtained from the cash flow statement, highlights the company’s ability to generate cash from its core business operations.
• Debt-to-Equity Ratio : (Total Liabilities / Shareholders' Equity) . This ratio, gathered from the balance sheet, reveals a company’s reliance on borrowed capital to finance operations. A higher ratio may signal higher financial risk.

By using the above metrics and indicators, you can confidently read and analyze an income statement, making informed decisions about a company’s financial performance and stability.

Comparing Income Statement to Other Financial Statements

Relation with balance sheet.

The income statement, also known as the P&L (profit and loss) statement, is one of the crucial financial statements businesses use to evaluate their financial performance. When comparing it to the balance sheet, it’s essential to understand the differences and connections between them. The income statement showcases a company’s revenues, expenses, and net income for a specific period, while the balance sheet presents a snapshot of a company’s assets, liabilities, and equity at a particular point in time.

One primary connection between the two statements is the net income , which is reflected in the retained earnings portion of the equity section on the balance sheet. The net income from the income statement flows into the balance sheet, affecting the retained earnings by either increasing it when the company makes a profit, or decreasing it in case of a loss.

Another vital link between the two statements is the cost of goods sold (COGS) on the income statement. COGS represents the cost of producing or acquiring the goods sold by a company. If a company purchases inventory, the balance sheet will reflect the change in inventory value while the income statement recognises the change in COGS, affecting the net income.

Link to Cash Flow Statement

The cash flow statement is another essential financial statement that demonstrates the flow of cash in three primary categories: operating, investing, and financing activities. While income statement shows whether the company is generating a profit, the cash flow statement provides insights into the company’s ability to generate cash.

There is a direct link between the income statement and cash flow statement, especially in the operating activities section. This section starts with the net income from the income statement and adjusts it for non-cash items such as depreciation and changes in working capital, including accounts receivable, accounts payable, and inventory.

It’s worth noting that a profitable company as shown in the income statement may not always have positive cash flow. This situation may arise due to various factors such as slow receivables collection, high inventory turnover, or significant capital expenditures. Therefore, comparing the income statement with the cash flow statement allows a more comprehensive analysis of a company’s financial stability and performance.

Frequently Asked Questions

What are the key components of an income statement.

An income statement consists of three main sections: revenue, expenses, and net income. Revenue represents the money generated by a business through sales and other services, while expenses cover the costs incurred in running the business, such as cost of goods sold, salaries, and overhead. Net income is the result of subtracting expenses from revenue and shows the company’s overall profitability during a specified period of time.

How can you interpret the company’s profitability from an income statement?

To gauge a company’s profitability, one can look at the net income figure on the income statement. If the net income is positive, it indicates that the company is earning more than it spends and is profitable. A negative net income shows that the company is spending more than it earns, resulting in a loss. Additionally, comparing net income figures over multiple periods can provide insights into the company’s financial health and the effectiveness of its strategies.

In what ways does the balance sheet differ from an income statement?

While an income statement displays a company’s financial performance over a specific period (e.g. a quarter or a year), a balance sheet provides a snapshot of a company’s financial position at a given moment in time. The balance sheet consists of assets, liabilities, and owners’ equity, revealing what the company owns, what it owes, and the equity owned by shareholders.

What steps should be followed to analyze an income statement effectively?

To analyze an income statement effectively, follow these steps:

• Examine the revenue trends: Assess whether the company’s revenue is growing, declining, or remaining consistent over time.
• Review the cost structure: Identify the major expenses and analyze how they are changing in relation to the revenue.
• Calculate the profit margins: Determine gross profit, operating profit, and net profit margins to understand how efficiently the company is operating.
• Compare with competitors: Evaluate the company’s performance against industry peers to identify strengths and weaknesses.
• Analyze the tax rate and interest expenses: These factors can have a significant impact on the company’s net income.

How does the profit and loss statement relate to an income statement?

A profit and loss (P&L) statement is another term for an income statement. It presents a company’s revenues, expenses, and net income (or loss) over a specified period, providing insights into the company’s profitability and financial performance.

What financial insights can be gleaned from comparing consecutive income statements?

Comparing consecutive income statements allows for the identification of trends and shifts in a company’s financial performance. By observing changes in revenue, expenses, and net income, one can gain insights into:

• How the company’s sales strategy is performing
• Fluctuations in production costs and their impact on profitability
• The efficiency of the company’s operations
• The effect of external financial factors, such as market changes or new competitors
• The overall financial health of the company over time
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• Income Statement

Home › Accounting › Financial Statements › Income Statement

• What is an Income Statement?

What is an Income Statement Used For?

Who uses an income statement, income statement format, single step income statement, common income statement questions.

The income statement, also called the  profit and loss statement , is a report that shows the income, expenses, and resulting profits or losses of a company during a specific time period. The income statement is the first  financial statement typically prepared during the  accounting cycle  because the net income or loss must be calculated and carried over to the statement of owner’s equity before other financial statements can be prepared.

The income statement calculates the  net income  of a company by subtracting total  expenses  from total  income . This calculation shows investors and creditors the overall profitability of the company as well as how efficiently the company is at generating profits from total revenues.

The income and expense accounts can also be subdivided to calculate gross profit and the income or loss from operations. These two calculations are best shown on a multi-step income statement. Gross profit is calculated by subtracting cost of goods sold from net sales. Operating income is calculated by subtracting operating expenses from the gross profit.

Unlike the balance sheet, the income statement calculates net income or loss over a range of time. For example annual statements use revenues and expenses over a 12-month period, while quarterly statements focus on revenues and expenses incurred during a 3-month period.

Income Statement Purpose

It’s important to note that there are several different types of income statements that are created for different reasons. For example, the year-end statement that is prepared annually for stockholders and potential investors doesn’t do much good for management while they are trying to run the company throughout the year. Thus, interim financial statements are prepared for management to check the status of operations during the year. Management also typically prepares departmental statements that break down revenue and expense numbers by business segment.

In the end, the main purpose of all profit and loss statements is to communicate the profitability and business activities of the company with end users. Each one of these end users has their own use for this information. Let’s look at who uses the P&L and what they use it for.

There are two different groups of people who use this financial statement: internal users and external users.

Internal users like company management and the board of directors use this statement to analyze the business as a whole and make decisions on how it is run. For example, they use performance numbers to gauge whether they should open new branch, close a department, or increase production of a product.

External users like investors and creditors, on the other hand, are people outside of the company who have no source of financial information about the company except published reports. Investors want to know how profitable a company is and whether it will grow and become more profitable in the future. They are mainly concerned with whether or not investing their money is the company with yield them a positive return.

Creditors, on the other hand, aren’t as concerned about profitability as investors are. Creditors are more concerned with a company’s cash flow and if they are generating enough income to pay back their loans.

Competitors are also external users of financial statements. They use competitors’ P&L to gauge how well other companies are doing in their space and whether or not they should enter new markets and try to compete with other companies.

There are two income statement formats that are generally prepared.

Single-step income statement   – the single step statement only shows one category of income and one category of expenses. This format is less useful of external users because they can’t calculate many efficiency and profitability ratios with this limited data.

Multi-step income statement  – the multi-step statement separates expense accounts into more relevant and usable accounts based on their function. Cost of goods sold, operating and non-operating expenses are separated out and used to calculate gross profit, operating income, and net income.

In both income statement formats, revenues are always presented before expenses. Expenses can be listed alphabetically or by total dollar amount. Either presentation is acceptable.

P&L expenses can also be formatted by the nature and the function of the expense.

All income statements have a heading that display’s the company name, title of the statement and the time period of the report. For example, an annual income statement issued by Paul’s Guitar Shop, Inc. would have the following heading:

• Paul’s Guitar Shop, Inc.
• For the Year Ended December 31, 2015

Income Statement Example

Here is an example of how to prepare an income statement from Paul’s  adjusted trial balance  in our earlier  accounting cycle  examples.

As you can see, this example income statement is a single-step statement because it only lists expenses in one main category. Although this statement might not be extremely useful for investors looking for detailed information, it does accurately calculate the net income for the year.

This net income calculation can be transferred to Paul’s  statement of owner’s equity  for preparation.

What is considered an expense on the income statement?

Expenses are outlays of resources for goods or services. These costs include wages, depreciation, and interest expense among others. They are reported on several sections of the income statement. Cost of goods sold expenses are reported in the gross profit reporting section while the operating expenses are reported in the operations section. Other expenses are reported further down the statement in the other gains and losses section.

How do you calculate the income statement?

The income statement is used to calculate the net income of a business. The P&L formula is Revenues – Expenses = Net Income. This is a simple equation that shows the profitability of a company. If revenue is higher than expenses, the company is profitable. If revenue is lower than expenses, the company is unprofitable.

What is a multi step income statement?

A multi-step statement splits the business activities into operating and non-operating categories. The operating section includes sales, cost of goods sold, and all selling and admin expenses. The non-operating section includes other income or expenses like interest or insurance proceeds.

How do you make an income statement?

Creating an income statement is fairly easy. Simply follow these steps:

• Determine the Time Period
• Transfer Income Accounts for Trial Balance into our template
• Transfer Expense Accounts for Trial Balance into our template
• Transfer Other Gains and Losses
• Calculate the Net Income

Use one of our templates to list the sales, expenses, and other gains or losses in the correct format. At the bottom of the statement, compute the net income for the company.

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Income Statement Analysis Guide & Free Essay Samples

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An income statement refers to a financial report that analyzes the company’s earnings and expenses over a specific period. This tool helps businesses cope with financial difficulties and inflation. The importance of an income statement lies in its ability to increase the organization’s profitability and avoid the expenditure of excess funds.

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Understanding the definition, types, and significance of an income statement is essential to comprehend how a business operates and how money flows in and out of a company.

What Is an Income Statement?

An income statement is one of 3 critical financial statements that a firm uses to report its financial performance over a specific period. The method compares a company’s revenue with its expenses to get the bottom line, which is the net profit or loss. Also, it helps analyze business efficiency and provides helpful insights into a company’s sales.

What Does an Income Statement Look Like?

The income statements can be different for various businesses but with the same set of data: total revenue , total expenses, and net income. These 3 components represent the very minimum of information. Additional details are typically given to help workers better understand the organization’s financial activity.

The income statement consists of the following components:

• Total revenue is the sum of money a company earns during a reporting period.
• Total expenses are the amount a company spends during a reporting period.
• Net income is total revenues minus all business expenses, including taxes, costs, and allowances.
• Costs of goods sold (COGS) are the direct costs of manufacturing the company’s products or services.
• Product-level revenue is the revenue linked to a specific product the company sells.
• Interest expense is the company’s interest payments on any borrowed funds.
• Gross profit is total revenue without COGS.
• Selling, general, and administrative expenses (SG&A) are all non-production costs associated with operating the company and selling the products. They include expenditures on advertising, bonuses, accounting, marketing, travel, etc.

Income statement analysis is the tool used to determine financial ratios that can be utilized to evaluate the company’s performance over time or compare one company with another. This report represents a firm’s financial situation and helps it create a strategic plan to strengthen its weak areas .

There are 2 types of income statement analysis: vertical and horizontal . They differ in how a statement is interpreted and what comparisons one can draw from them.

Vertical analysis is a financial analysis in which each line item in the statement is represented as a percentage of a base figure, namely, gross sales . It involves reading down one column of data and comparing elements with each other. For example, one can determine the relative size of various expenses within operating expenses. Since the company can examine relative proportions, this analysis makes it straightforward to compare financial statements across periods, industries, and firms. Investors use this strategy to delve deeply into a company’s current position regarding such ratios as total assets and working capital .

In contrast, a horizontal analysis looks at the same figure across different reporting periods. The method usually involves comparing absolute values but can also be represented as a percentage of the dollar amount in the base year. Companies use a horizontal analysis to determine their financial performance over time, discover trends , and find factors contributing to their success or failure.

The income statement has several limits, so it is not always the best source of information. For example, it only shows part of the bigger picture since it does not show the purchases made using a credit card or cash. Also, the income report frequently employs estimations rather than exact numbers. That is why making important decisions and analyzing broad concepts can be challenging.

We have prepared several helpful tips on how to read the income statement to receive as many benefits as possible:

• Examine all of the math. Analyzing math data is crucial to uncovering mistakes and better understanding how numbers work.
• Identify the bottom line. The bottom line will aid in creating a strategic plan for saving money in case the company has many extra expenses.
• Take a look at the revenue sources. Analyzing the revenue sources will assist in creating a revenue model suitable for your business.
• Consider the expenses. You need to learn why the business is borrowing money to find a solution to its financial problems.
• Compare numbers for each year. Analyzing performance changes over time will help avoid possible risky situations.

Income statements are essential decision-making tools. Companies turn to them when choosing a growth strategy or deciding to cut expenses. Hopefully, this article has given you some insights into income statement analysis. Don’t miss the examples below!

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How to Prepare an Income Statement

• 09 Dec 2021

When it comes to financial statements , each communicates specific information and is needed in different contexts to understand a company’s financial health.

The income statement is one of the most important financial statements because it details a company’s income and expenses over a specific period. This document communicates a wealth of information to those reading it—from key executives and stakeholders to investors and employees. Being able to read an income statement is important, but knowing how to generate one is just as critical.

Here’s an overview of the information found in an income statement, along with a step-by-step look at the process of preparing one for your organization.

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What Is an Income Statement?

An income statement is a financial report detailing a company’s income and expenses over a reporting period. It can also be referred to as a profit and loss (P&L) statement and is typically prepared quarterly or annually.

Income statements depict a company’s financial performance over a reporting period. Because the income statement details revenues and expenses, it provides a glimpse into which business activities brought in revenue and which cost the organization money—information investors can use to understand its health and executives can use to find areas for improvement.

Related: How to Read & Understand an Income Statement

An income statement typically includes the following information:

• Revenue: How much money a business took in during a reporting period
• Expenses: How much money a business spent during a reporting period
• Costs of goods sold (COGS): The total costs associated with component parts of whatever product or service a company makes and sells
• Gross profit: Revenue minus costs of goods sold
• Operating income: Gross profit minus operating expenses
• Income before taxes: Operating income minus non-operating expenses
• Net income: Income before taxes
• Earnings per share (EPS): Net income divided by the total number of outstanding shares
• Depreciation: Value lost by assets, such as inventory, equipment, and property, over time
• EBITDA: Earnings before interest, depreciation, taxes, and amortization

Related: 13 Financial Performance Measures Managers Should Monitor

Steps to Prepare an Income Statement

1. choose your reporting period.

Your reporting period is the specific timeframe the income statement covers. Choosing the correct one is critical.

Monthly, quarterly, and annual reporting periods are all common. Which reporting period is right for you depends on your goals. A monthly report, for example, details a shorter period, making it easier to apply tactical adjustments that affect the next month’s business activities. A quarterly or annual report, on the other hand, provides analysis from a higher level, which can help identify trends over the long term.

2. Calculate Total Revenue

Once you know the reporting period, calculate the total revenue your business generated during it.

If you prepare the income statement for your entire organization, this should include revenue from all lines of business. If you prepare the income statement for a particular business line or segment, you should limit revenue to products or services that fall under that umbrella.

3. Calculate Cost of Goods Sold (COGS)

Next, calculate the total cost of goods sold for any product or service that generated revenue for your business during the reporting period. This encompasses direct and indirect costs of producing and selling products or services, including:

• Direct labor expenses
• Material expenses
• Parts or component expenses
• Distribution costs
• Any expense directly tied to the production of your product or service

4. Calculate Gross Profit

The next step is to determine gross profit for the reporting period. To calculate this, simply subtract the cost of goods sold from revenue.

5. Calculate Operating Expenses

Once you know gross profit, calculate operating expenses (OPEX).

Operating expenses are indirect costs associated with doing business. These differ from cost of goods sold because they’re not directly associated with the process of producing or distributing products or services. Examples of expenses that fall under the OPEX category include:

• Office supplies

6. Calculate Income

To calculate total income, subtract operating expenses from gross profit. This number is essentially the pre-tax income your business generated during the reporting period. This can also be referred to as earnings before interest and taxes (EBIT).

7. Calculate Interest and Taxes

After calculating income for the reporting period, determine interest and tax charges.

Interest refers to any charges your company must pay on the debt it owes. To calculate interest charges, you must first understand how much money you owe and the interest rate being charged. Accounting software often automatically calculates interest charges for the reporting period.

Next, calculate your total tax burden for the reporting period. This includes local, state, and federal taxes, as well as any payroll taxes.

8. Calculate Net Income

The final step is to calculate net income for the reporting period. To do this, subtract interest and then taxes from your EBIT. The number remaining reflects your business’s available funds, which can be used for various purposes, such as being added to a reserve, distributed to shareholders, utilized for research and development, or to fuel business expansion.

Income Statement Example

Below is an example income statement for a fictional company. As you can see at the top, the reporting period is for the year that ended on Sept. 28, 2019.

Go to the alternative version .

During the reporting period, the company made approximately $4.4 billion in total sales. It cost the business approximately $2.7 billion to achieve those sales. As a result, gross profit was about $1.6 billion.

Next, $560.4 million in selling and operating expenses and $293.7 million in general administrative expenses were subtracted. This left the company with an operating income of $765.2 million. To this, additional gains were added and losses subtracted, including $257.6 million in income tax.

At the bottom of the income statement, it’s clear the business realized a net income of $483.2 million during the reporting period.

A Critical Skill for Business Leaders

Although the income statement is typically generated by a member of the accounting department at large organizations, knowing how to compile one is beneficial to a range of professionals.

Whether you’re an individual contributor, a member of the leadership team in a non-accounting role, or an entrepreneur who wears many hats, learning how to create an income statement can provide a deeper understanding of the financial metrics that matter to your business. It can also help improve your financial analysis capabilities .

Do you want to take your career to the next level? Consider enrolling in Financial Accounting —one of three courses comprising our Credential of Readiness (CORe) program —which can teach you the key financial topics you need to understand business performance and potential. Not sure which course is right for you? Download our free flowchart .

Data Tables

Company b income statement.

For Year Ended September 28, 2019 (In thousands)

Go back to the article .

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Income Statement Analysis

By Sam Williams |

October 27, 2020

What is “Income Statement Analysis”?

The income statement presents all the income and expenses a company incurs over a period of time. We use various ratios to assess the company’s performance over time and make forecasts/predictions. The most common ratios are:

• Sales growth
• Gross profit / sales (“Gross margin”)
• Operating profit / sales (“Operating margin”)
• Net income / sales (“Net margin”)
• EBIT / sales (“EBIT margin”)
• EBITDA / sales (“EBITDA margin”)

On their own, these ratios will not offer more than just a number. Instead, they can be used as comparable metrics by comparing a company’s profitability from one year to the next or with a competitor for the same period.

Key Learning Points

• The income statement reports the changes between the retained earnings ending balance between two accounting periods
• The statement presents all the income and expenses a company incurs over a period of time
• There are many financial metrics which can be used to help understand the operational performance and profitability of the business
• EBIT represents the profit generated from a company’s operations after excluding non-recurring items
• Financial ratios are useful but should rarely be analyzed on their own. Instead, they provide a much better indication of a company’s performance when compared to historic data or other companies operating in similar industries

Coca-Cola vs PepsiCo

To demonstrate these ratios, let’s look at the comparison between two similar companies. We will use Coca-Cola vs Pepsi for the year-ended 2017:

The Coca Cola Company – Income Statement 2017 Extract

PepsiCo Inc – Income Statement 2017 Extract

The first step is to review the income statements and identify the items needed for the margin calculations. All figures reported in the table are in $ millions.

Operating Margin

Net Income Margin

The operating margin is calculated by dividing the reported operating profit by the sales for that period. The results show that for every 100 dollars of profit made, $21 dollars is contributing towards Coca-Cola’s operating profit and $17 dollars towards Pepsi’s. This shows that Coca-Cola are managing their costs more efficiently to generate a profit. Pepsi who operate in a similar industry will want to review their pricing strategy and direct materials costs.

Net income is the total profit available after all expenses have been deducted for the period. The net income margin shows the percentage of revenue left after all expenses have been deducted. This is another profitability ratio which measures the amount of net income generated in relation to a company’s sales.

EBIT Margin

Earnings before interest or tax (EBIT) is a calculated figure which shows the profitability of a company from its operations after excluding non-recurring items. Excluding these items can improve comparisons with competitors as well as providing a useful starting point for predicting future profitability.

For many companies, this figure may be the same as operating profit and it’s up to the analyst to decide which items need adjusting to generate a “clean EBIT” figure. The calculation starts with operating profit and adjustments are made for any deemed non-recurring items.

For Coca-Cola, there is a line item in their income statement called “other operating charges”. It is not clear what this item includes and is a good place to start.

The MD&A or footnotes usually provide us with more information on these items. Below is an extract from Coca-Cola’s 8-K report, which highlights non-recurring items identified by management including the amounts involved in other operating charges.

Extract from Coca-Cola’s Reported (GAAP) Fourth Quarter and Full-Year 2017 Results

For PepsiCo, the income statement itself doesn’t highlight any non-recurring items. However, the MD&A does provide some detail on these, as shown in PepsiCo’s 8-K extract below.

Extract from PepsiCo Inc Reported (GAAP) Fourth Quarter and Full-Year 2017 Results

We now need to decide which items above we view as non-recurring. We then add them back to the operating profit line for a “clean EBIT” figure.

The table below includes the reported operating profit with a list of all the non-recurring items that can be added back to the earnings figure. The adjusted operating profit figure shows a large increase for Coca-Cola in comparison to the operating profit margin (21% to 27%). This shows the profitability generated from operations is much greater when excluding non-recurring items, as the company is undergoing a large restructuring program.

PepsiCo only had one item added back to their operating profit figure. Due to their high sales figure for the period, this made little difference to the margin (remains at 17%).

EBITDA Margin

Earnings before interest, tax, interest, depreciation and amortization is calculated by taking our EBIT number and adding back the expenses relating to long lived assets. Companies may have different depreciation and amortization policies for these assets, resulting in a larger (or smaller) expense. This will in turn reduce (or increase) their EBIT. Adding back these expenses can make it easier to compare with competitors.

The EBIT figure has already been calculated, so the depreciation and amortization expense (“D&A”) needs to be identified from the statements and added back. The figures can be found in the statement of cash flows under operating activities.

Extract from Coca-Cola Statement of Cash Flow 2017

Extract from PepsiCo Statement of Cash Flow 2017

The table below shows the EBITDA figure calculation using our EBIT figure from above and the reported D&A figure. The margin can be calculated by dividing EBITDA by the sales for the same period.

We notice that Coca-Cola has an EBITDA margin of 31%, which is higher than the PepsiCo’s EBITDA margin of 21%.

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Types of Financial Statements

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Financial Statement Analysis: How It’s Done, by Statement Type

Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.

What Is Financial Statement Analysis?

Financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization and to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

Key Takeaways

• Financial statement analysis is used by internal and external stakeholders to evaluate business performance and value.
• Financial accounting calls for all companies to create a balance sheet, income statement, and cash flow statement, which form the basis for financial statement analysis.
• Horizontal, vertical, and ratio analysis are three techniques that analysts use when analyzing financial statements.

Jiaqi Zhou / Investopedia

How to Analyze Financial Statements

The financial statements of a company record important financial data on every aspect of a business’s activities. As such, they can be evaluated on the basis of past, current, and projected performance.

In general, financial statements are centered around generally accepted accounting principles (GAAP) in the United States. These principles require a company to create and maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies have stricter standards for financial statement reporting. Public companies must follow GAAP, which requires accrual accounting. Private companies have greater flexibility in their financial statement preparation and have the option to use either accrual or cash accounting.

Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques are horizontal analysis , vertical analysis , and ratio analysis . Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis looks at the vertical effects that line items have on other parts of the business and the business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships.

Companies use the balance sheet, income statement, and cash flow statement to manage the operations of their business and to provide transparency to their stakeholders. All three statements are interconnected and create different views of a company’s activities and performance.

Balance Sheet

The balance sheet is a report of a company’s financial worth in terms of book value. It is broken into three parts to include a company’s assets ,  liabilities , and  shareholder equity . Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency; liabilities include the company’s expense arrangements and the debt capital it is paying off; and shareholder equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance assets and liabilities to equal shareholder equity. This figure is considered a company’s book value and serves as an important performance metric that increases or decreases with the financial activities of a company.

Income Statement

The income statement breaks down the revenue that a company earns against the expenses involved in its business to provide a bottom line, meaning the net profit or loss. The income statement is broken into three parts that help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit . It then moves to operating profit , which subtracts indirect expenses like marketing costs, general costs, and depreciation. Finally, after deducting interest and taxes, the net income is reached.

Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin, which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company’s cash flows from operating activities, investing activities, and financing activities. Net income is carried over to the cash flow statement, where it is included as the top line item for operating activities. Like its title, investing activities include cash flows involved with firm-wide investments. The financing activities section includes cash flow from both debt and equity financing. The bottom line shows how much cash a company has available.

Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a company . Free cash flow statements arrive at a net present value by discounting the free cash flow that a company is estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially going public.

Financial statements are maintained by companies daily and used internally for business management. In general, both internal and external stakeholders use the same corporate finance methodologies for maintaining business activities and evaluating overall financial performance .

When doing comprehensive financial statement analysis, analysts typically use multiple years of data to facilitate horizontal analysis. Each financial statement is also analyzed with vertical analysis to understand how different categories of the statement are influencing results. Finally, ratio analysis can be used to isolate some performance metrics in each statement and bring together data points across statements collectively.

Below is a breakdown of some of the most common ratio metrics:

• Balance sheet : This includes asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity.
• Income statement : This includes gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage.
• Cash flow : This includes cash and earnings before interest, taxes, depreciation, and amortization (EBITDA) . These metrics may be shown on a per-share basis.
• Comprehensive : This includes return on assets (ROA) and return on equity (ROE) , along with DuPont analysis .

What are the advantages of financial statement analysis?

The main point of financial statement analysis is to evaluate a company’s performance or value through a company’s balance sheet, income statement, or statement of cash flows. By using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may develop a more nuanced picture of a company’s financial profile.

What are the different types of financial statement analysis?

Most often, analysts will use three main techniques for analyzing a company’s financial statements.

First, horizontal analysis involves comparing historical data. Usually, the purpose of horizontal analysis is to detect growth trends across different time periods.

Second, vertical analysis compares items on a financial statement in relation to each other. For instance, an expense item could be expressed as a percentage of company sales.

Finally, ratio analysis, a central part of fundamental equity analysis, compares line-item data. Price-to-earnings (P/E) ratios, earnings per share, or dividend yield are examples of ratio analysis.

What is an example of financial statement analysis?

An analyst may first look at a number of ratios on a company’s income statement to determine how efficiently it generates profits and shareholder value. For instance, gross profit margin will show the difference between revenues and the cost of goods sold. If the company has a higher gross profit margin than its competitors, this may indicate a positive sign for the company. At the same time, the analyst may observe that the gross profit margin has been increasing over nine fiscal periods, applying a horizontal analysis to the company’s operating trends.

Congressional Research Service. “ Cash Versus Accrual Basis of Accounting: An Introduction ,” Page 3 (Page 7 of PDF).

Internal Revenue Service. “ Publication 538 (01/2022), Accounting Periods and Methods: Methods You Can Use. ”

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Financial Ratio Analysis Tutorial With Examples

The Balance Sheet for Financial Ratio Analysis

The income statement for financial ratio analysis, analyzing the liquidity ratios, the current ratio, the quick ratio, analyzing the asset management ratios accounts receivable, receivables turnover, average collection period, inventory, fixed assets, total assets, inventory turnover ratio, fixed asset turnover, total asset turnover, analyzing the debt management ratios, debt-to-asset ratio, times interest earned ratio, fixed charge coverage, analyzing the profitability ratios, net profit margin, return on assets, return on equity, financial ratio analysis of xyz corporation.

While it may be more fun to work on marketing efforts, the financial management of a firm is a crucial aspect of owning a business. Financial ratios help break down complex financial information into key details and relationships. Financial ratio analysis involves studying these ratios to learn about the company's financial health.

Here are a few of the most important financial ratios for business owners to learn, what they tell you about the company's financial statements , and how to use them.

Key Takeaways

• Some of the most important financial ratios for business owners include the current ratio, the inventory turnover ratio, and the debt-to-asset ratio.
• These financial ratios quickly break down the complex information from financial statements.
• Financial ratios are snapshots, so it's important to compare the information to previous periods of data as well as competitors in the industry.

Here is the balance sheet we are going to use for our financial ratio tutorial. You will notice there are two years of data for this company so we can do a time-series (or trend) analysis and see how the firm is doing across time.

Here is the complete income statement for the firm for which we are doing financial ratio analysis. We are doing two years of financial ratio analysis for the firm so we can compare them.

Refer back to the income statement and balance sheet as you work through the tutorial.

The first ratios to use to start getting a financial picture of your firm measure your liquidity, or your ability to convert your current assets to cash quickly. They are two of the 13 ratios. Let's look at the current ratio and the quick (acid-test) ratio .

The current ratio measures how many times you can cover your current liabilities. The quick ratio measures how many times you can cover your current liabilities without selling any inventory and so is a more stringent measure of liquidity.

Remember that we are doing a time series analysis, so we will be calculating the ratios for each year.

Current Ratio : For 2020, take the Total Current Assets and divide them by the Total Current Liabilities. You will have: Current Ratio = 642/543 = 1.18X. This means that the company can pay for its current liabilities 1.18 times over. Practice calculating the current ratio for 2021.

Your answer for 2021 should be 1.31X. A quick analysis of the current ratio will tell you that the company's liquidity has gotten just a little bit better between 2020 and 2021 since it rose from 1.18X to 1.31X.

Quick Ratio : In order to calculate the quick ratio, take the Total Current Ratio for 2020 and subtract out Inventory. Divide the result by Total Current Liabilities. You will have: Quick Ratio = (642-393)/543 = 0.46X. For 2021, the answer is 0.52X.

Like the current ratio, the quick ratio is rising and is a little better in 2021 than in 2020. The firm's liquidity is getting a little better. The problem for this company, however, is that they have to sell inventory in order to pay their short-term liabilities and that is not a good position for any firm to be in. This is true in both 2020 and 2021.

This firm has two sources of current liabilities: accounts payable and notes payable. They have bills that they owe to their suppliers (accounts payable) plus they apparently have a bank loan or a loan from some alternative source of financing. We don't know how often they have to make a payment on the note.

Asset management ratios are the next group of financial ratios that should be analyzed. They tell the business owner how efficiently they employ their assets to generate sales. Assume all sales are on credit.

• Receivables Turnover = Credit Sales/Accounts Receivable = ___ X so:
• Receivables Turnover = 2,311/165 = 14X

A receivables turnover of 14X in 2020 means that all accounts receivable are cleaned up (paid off) 14 times during the 2020 year. For 2021, the receivables turnover is 15.28X. Look at 2020 and 2021 Sales in The Income Statement and Accounts Receivable in The Balance Sheet.

The receivables turnover is rising from 2020 to 2021. We can't tell if this is good or bad. We would really need to know what type of industry this firm is in and get some industry data to compare to.

Customers paying off receivables is, of course, good. But, if the receivables turnover is way above the industry's, then the firm's credit policy may be too restrictive.

Average collection period is also about accounts receivable. It is the number of days, on average, that it takes a firm's customers to pay their credit accounts. Together with receivables turnover, average collection helps the firm develop its credit and collections policy.

• Average Collection Period = Accounts Receivable/Average Daily Credit Sales*
• *To arrive at average daily credit sales, take credit sales and divide by 360
• Average Collection Period = $165/2311/360 = $165/6.42 = 25.7 days
• In 2021, the average collection period is 23.5 days

From 2020 to 2021, the average collection period is dropping. In other words, customers are paying their bills more quickly. Compare that to the receivables turnover ratio. Receivables turnover is rising and the average collection period is falling.

This makes sense because customers are paying their bills faster. The company needs to compare these two ratios to industry averages. In addition, the company should take a look at its credit and collections policy to be sure they are not too restrictive. Take a look at the image above and you can see where the numbers came from on the balance sheets and income statements.

Along with the accounts receivable ratios that we analyzed above, we also have to analyze how efficiently we generate sales with our other assets: inventory, plant and equipment, and our total asset base.

The inventory turnover ratio is one of the most important ratios a business owner can calculate and analyze. If your business sells products as opposed to services, then inventory is an important part of your equation for success.

Inventory Turnover = Sales/Inventory = ______ X

If your inventory turnover is rising, that means you are selling your products faster. If it is falling, you are in danger of holding obsolete inventory. A business owner has to find the optimal inventory turnover ratio where the ratio is not too high and there are no stockouts or too low where there is obsolete money. Both are costly to the firm.

For this company, their inventory turnover ratio for 2020 is:

Inventory Turnover Ratio = Sales/Inventory = 2311/393 = 5.9X

This means that this company completely sells and replaces its inventory 5.9 times every year. In 2021, the inventory turnover ratio is 6.8X. The firm's inventory turnover is rising. This is good in that they are selling more products. The business owner should compare the inventory turnover with the inventory turnover ratio with other firms in the same industry.

The fixed asset turnover ratio analyzes how well a business uses its plant and equipment to generate sales. A business firm does not want to have either too little or too much plant and equipment. For this firm for 2020:

Fixed Asset Turnover = Sales/Fixed Assets = 2311/2731 = 0.85X

For 2021, the fixed asset turnover is 1.00. The fixed asset turnover ratio is dragging down this company. They are not using their plant and equipment efficiently to generate sales as, in both years, fixed asset turnover is very low.

The total asset turnover ratio sums up all the other asset management ratios. If there are problems with any of the other total assets, it will show up here, in the total asset turnover ratio.

Total Asset Turnover = Sales/Total Asset Turnover = Sales/Total Assets = 2311/3373 = 0.69X for 2020. For 2021, the total asset turnover is 0.80. The total asset turnover ratio is somewhat concerning since it was not even 1X for either year.

This means that it was not very efficient. In other words, the total asset base was not very efficient in generating sales for this firm in 2020 or 2021. Why?

It seems to me that most of the problem lies in the firm's fixed assets. They have too much plant and equipment for their level of sales. They either need to find a way to increase their sales or sell off some of their plant and equipment. The fixed asset turnover ratio is dragging down the total asset turnover ratio and the firm's asset management in general.

There are three debt management ratios that help a business owner evaluate the company in light of its asset base and earning power. Those ratios are the debt-to-asset ratio, the times interest earned ratio , and the fixed charge coverage ratios. Other debt management ratios exist, but these help give business owners the first look at the debt position of the company and the prudence of that debt position.

The first debt ratio that is important for the business owner to understand is the debt-to-asset ratio ; in other words, how much of the total asset base of the firm is financed using debt financing. For example. the debt-to-asset ratio for 2020 is:

Total Liabilities/Total Assets = $1074/3373 = 31.8%. This means that 31.8% of the firm's assets are financed with debt. In 2021, the debt ratio is 27.8%. In 2021, the business is using more equity financing than debt financing to operate the company.

We don't know if this is good or bad since we do not know the debt-to-asset ratio for firms in this company's industry. However, we do know that the company has a problem with its fixed asset ratio which may be affecting the debt-to-asset ratio.

The times interest earned ratio tells a company how many times over a firm can pay the interest that it owes. Usually, the more times a firm can pay its interest expense the better. The times interest earned ratio for this firm for 2020 is:

• Times Interest Earned = Earnings Before Interest and Taxes/Interest = 276/141 = 1.96X
• For 2021, the times interest earned ratio is 3.35

The times interest earned ratio is very low in 2020 but better in 2021. This is because the debt-to-asset ratio dropped in 2021.

The fixed charge coverage ratio is very helpful for any company that has any fixed expenses they have to pay. One fixed charge (expense) is interest payments on debt, but that is covered by the times interest earned ratio.

Another fixed charge would be lease payments if the company leases any equipment, a building, land, or anything of that nature. Larger companies have other fixed charges which can be taken into account.

• Fixed charge coverage = Earnings Before Fixed Charges and Taxes/Fixed Charges = _____X

In both 2020 and 2021 for the company in our example, its only fixed charge is interest payments. So, the fixed charge coverage ratio and the times interest earned ratio would be exactly the same for each year for each ratio.

The last group of financial ratios that business owners usually tackle are the profitability ratios as they are the summary ratios of the 13 ratio group. They tell the business firm how they are doing on cost control, efficient use of assets, and debt management, which are three crucial areas of the business.

The net profit margin measures how much each dollar of sales contributes to profit and how much is used to pay expenses. For example, if a company has a net profit margin of 5%, this means that 5 cents of every sales dollar it takes in goes to profit and 95 cents goes to expenses. For 2020, here is XYZ, Inc's net profit margin:

Net Profit Margin = Net Income/Sales Revenue = 89.1/2311 = 3.9%

For 2021, the net profit margin is 6.5%, so there was quite an increase in their net profit margin. You can see that their sales took quite a jump but their cost of goods sold rose. It is the best of both worlds when sales rise and costs fall. Bear in mind, the company can still have problems even if this is the case.

The return on assets ratio, also called return on investment , relates to the firm's asset base and what kind of return they are getting on their investment in their assets. Look at the total asset turnover ratio and the return on asset ratio together. If total asset turnover is low, the return on assets is going to be low because the company is not efficiently using its assets.

Another way to look at the return on assets is in the context of the Dupont method of financial analysis. This method of analysis shows you how to look at the return on assets in the context of both the net profit margin and the total asset turnover ratio.

• To calculate the Return on Assets ratio for XYZ, Inc. for 2020, here's the formula:
• Return on Assets = Net Income/Total Assets = 2.6%

For 2021, the ROA is 5.2%. The increased return on assets in 2021 reflects the increased sales and much higher net income for that year.

The return on equity ratio is the one of most interest to the shareholders or investors in the firm. This ratio tells the business owner and the investors how much income per dollar of their investment the business is earning. This ratio can also be analyzed by using the Dupont method of financial ratio analysis. The company's return on equity for 2020 was:

Return on Equity = Net Income/Shareholder's Equity = 3.9%

For 2021, the return on equity was 7.2%. One reason for the increased return on equity was the increase in net income. When analyzing the return on equity ratio, the business owner also has to take into consideration how much of the firm is financed using debt and how much of the firm is financed using equity.

Now we have a summary of all 13 financial ratios for XYZ Corporation. The first thing that jumps out is the low liquidity of the company. We can look at the current and quick ratios for 2020 and 2021 and see that the liquidity is slightly increasing between 2020 and 2021, but it is still very low.

By looking at the quick ratio for both years, we can see that this company has to sell inventory in order to pay off short-term debt. The company does have short-term debt: accounts payable and notes payable, and we don't know when the notes payable will come due.

Let's move on to the asset management ratios. We can see that the firm's credit and collections policies might be a little restrictive by looking at the high receivable turnover and low average collection period. Customers must pay this company rapidly—perhaps too rapidly. There is nothing particularly remarkable about the inventory turnover ratio, but the fixed asset turnover ratio is remarkable.

The fixed asset turnover ratio measures the company's ability to generate sales from its fixed assets or plant and equipment. This ratio is very low for both 2020 and 2021. This means that XYZ has a lot of plant and equipment that is unproductive.

It is not being used efficiently to generate sales for the company. In addition, the company has to service the plant and equipment, pay for breakdowns, and perhaps pay interest on loans to buy it through long-term debt.

It seems that a very low fixed asset turnover ratio might be a major source of problems for XYZ. The company should sell some of this unproductive plant and equipment, keeping only what is absolutely necessary to produce their product.

The low fixed asset turnover ratio is dragging down total asset turnover. If you follow this analysis on through, you will see that it is also substantially lowering this firm's return on assets profitability ratio.

With this firm, it is hard to analyze the company's debt management ratios without industry data. We don't know if XYZ is a manufacturing firm or a different type of firm.

As a result, analyzing the debt-to-asset ratio is difficult. What we can see, however, is that the company is financed more with shareholder funds (equity) than it is with debt as the debt-to-asset ratio for both years is under 50% and dropping.

This fact means that the return on equity profitability ratio will be lower than if the firm was financed more with debt than with equity. On the other hand, the risk of bankruptcy will also be lower.

Unfortunately, you can see from the times interest earned ratio that the company does not have enough liquidity to be comfortable servicing its debt. The company's costs are high and liquidity is low. Fortunately, the company's net profit margin is increasing because their sales are increasing.

Hopefully, this is a trend that will continue. Return on Assets is impacted negatively due to the low fixed asset turnover ratio and, to some extent, by the receivables ratios. Return on Equity is increasing from 2020 to 2021, which will make investors happy.

As you can see, it is possible to do a cursory financial ratio analysis of a business firm with only 13 financial ratios, even though ratio analysis has inherent limitations.

Wells Fargo. " 5 Ways To Improve Your Liquidity Ratio ."

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.2 Operating Efficiency Ratios ." OpenStax, 2022.

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 2, 4.

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 3, 6.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.4 Solvency Ratios ." OpenStax, 2022.

Nasdaq. " Fixed-Charge Coverage Ratio ."

U.S. Small Business Administration. " Calculate & Analyze Your Financial Ratios ," Pages 3, 5.

Julie Dahlquist, Rainford Knight. " Principles of Finance: 6.6 Profitability Ratios and the DuPont Method ." OpenStax, 2022.

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Financial Statement Analysis

Checked : Mark A. , Curtis H.

Latest Update 21 Jan, 2024

Table of content

The components of the financial statement

1. the balance sheet, 2. the income statement, 3. the cash flow table.

• Understanding a company's financial statements in 5 points

Financial statement objectives

Evaluate performance and plan for the future, assess the financial strength of a business, analyze the solvency of the organization.

To analyze the performance and manage the growth of a company, financial statements are a handy tool.

A financial statement is a summary document drawn up periodically. Information on performance, financial and accounting situation, and the development of a company from one accounting year to the next appears.

It is presented in an organized and standardized manner and is based on the following concepts and obligations:

• Faithful image and compliant with IFRS (International Financial Reporting Standards, which have been the accounting standard applicable to companies listed on the European market since 2005). The financial statements must be structured and presented in a clear manner and in accordance with the transactions and the facts.
• Going concern: financial statements must be prepared on the assumption that the company will continue its activities for an indefinite period
• Commitment accounting: Expenses and income must be allocated to the period during which they were incurred and attach these funds at the close
• Consistency of presentation: The presentation and classification of items in the financial statements must remain unchanged from one financial year to the next unless there are changes imposed by IFRS standards
• Relative importance and grouping: each significant category of similar elements must be presented separately in the financial statements unless they are not significant
• Non-offsetting of assets, liabilities, charges, and income: Assets, liabilities, charges, and income should not be offset against each other unless required by an IFRS standard
• Comparative information with the previous period: the financial statements must give corresponding information from previous years to allow users to compare the financial situation and the performance of a company over time

is a basic summary table which gives an image of the company's financial situation during a period and presents three main elements:

• The asset: economic resources controlled by the company from which it expects future economic benefits, or simply what the company has
• Liabilities: obligation to do or pay, which represents a negative value for the company, or what the company has to pay
• Equity: net worth of the company resulting from the difference between assets and liabilities.

commonly called the statement of comprehensive income or PP (loss and profit), is an accounting document that gives an image of the company's economic performance over a given period in terms of gains or losses.

It provides information on what   the business   has gained and spent and then indicates whether it has made a profit or a loss during the accounting period.

It is the difference between the products, which are the operations that increase the wealth of the company and the charges, which are the consumption of resources that impoverishes the company. The income statement provides useful information on the company's dynamics and its ability to generate profit as well as its positioning in relation to its competitors.

details and explains the change in cash during the entire accounting year. These are the company's bottom-line inflows and outflows for paying off debts and purchasing the products it needs.

The flows are classified into three categories:

• The flows linked to the company's operational activity: They define the variation of the company's liquidities held by the company linked to its main activity.
• Flows linked to   investment   activities: They represent all the expenses and income associated with acquisitions and disposals of fixed assets.
• Cash flows linked to financing activities: They mainly relate to capital increases and reductions, the payment of dividends to shareholders, and the obtaining or repayment of financial loans.
• The statement of changes in equity indicates all the transactions that affect an enterprise's total equity during an accounting year. It identifies the wealth created and/or potentially available to shareholders.
• The appendices are mandatory or significant documents intended to clarify the reading of the balance sheet and the income statement. It also provides useful qualitative information, but absent from the financial statements. For instance, the accounting practices and standards on which the financial statements are established, provisions, pension funds, discontinued operations, dispute resolution, disposal of tangible capital assets, the number of dividends proposed or decided, etc. as well as any other relevant information that could impact the company.

No single financial statement gives a complete picture of the business. They are all linked. The change in assets and liabilities arising from the balance sheet corresponds to the charges and income appearing in the income statement, which determines the company's gains or losses. The cash flows provide additional information on the liquid assets listed in the balance sheet. Financial statements are a valuable source of information for investors and donors for economic decision-making.

Understanding a company's financial statements in 5 points

The financial statements of a company show its economic situation in different aspects. A management tool, these summary documents allow members of the board of directors and managers to make informed decisions in the light of complete and reliable information and to provide third parties with a true picture of the company's situation. Here's how to understand a company's financial statements in 5 points. Three main documents

There are three main types of financial statements:

• the balance sheet which presents a photograph of the assets (assets), debts (liabilities), and assets of shareholders or associates (equity) of the company at the end of the past financial year
• the income statement which lists the revenues (products) and expenses (expenses) over a year
• the statement of changes in a financial position which provides information on the company's operating, financing and investing activities

Quebec law imposes an obligation on companies to present financial statements for the year ended during the annual general meeting. The board of directors has a photograph of the company's economic situation and a report on the past year of activity. The financial statements provide:

• business assets and liabilities
• The charges.

But financial statements also have other uses:

• they help the manager make informed decisions
• they serve as the basis for establishing the price during a transfer
• they allow investors and lenders to analyze the company's situation before deciding to inject funds or finance the development of the activity
• they support an insurance compensation claim in the event of a business interruption linked to a disaster

The income statement lists the company's revenues and expenses over a year. It allows you to see whether the financial year is profitable or loss-making and, in particular, to compare each item of expenditure and each category of product with the forecast budget and previous years. Thus, the organization can determine whether the strategic plans are being followed or whether they require a reassessment or even a modification.

The income statement also serves as the basis for establishing the budgets for the coming years by integrating changes linked to the economic situation (increase in the prices of raw materials, the cost of labor, etc.) and managerial decisions (such as an example of hiring or, on the contrary, job cuts, changes of premises, the opening or closing of a department).

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In addition to revealing the assets and liabilities of a company, the balance sheet also provides information on the equity of the organization and makes it possible to analyze its financial solidity as well as its capacity to absorb any operating losses.

The statement of changes in financial position is an indicator of a company's cash flows from operating, investing, and financing activities. It allows:

• collect information on accounts receivable and payable
• monitor purchases and sales of fixed assets
• to examine the methods of financing purchases and the repayment of debts

These elements help to assess the liquidity and the solvency of the company and to determine its capacity to self-finance and to repay its debts.

The annual production of financial statements does not only satisfy a legal obligation. It provides economic data relating to the company's state and development, which helps the manager make informed decisions. It gives a true and complete picture of the organization's situation to third parties.

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How to Do a Monthly Income Statement Analysis That Fuels Growth

Posted july 6, 2021 by noah parsons.

As an entrepreneur or business owner, you need to get to know your income statement. This critical document not only helps you understand the health of your business but where there may be potential risks, opportunities, and issues that need to be addressed. It’s a document that when read and analyzed can help inform your business strategy , set more accurate milestones , and better inform the goals you set for you and your team.

Like any financial statement, it can be a daunting task to try and understand how to read and analyze your income statement. But by taking the time to learn how, setting up a consistent review process, and equipping yourself with the right tools — it can become a fruitful and simple exercise. Let’s dive into how you can use your income statement to build a stronger and healthier business.

What is a monthly income statement?

Your income statement, also known as the profit and loss statement (P&L), summarizes your business revenue and operating expenses over a period of time. This is the most popular and most common financial statement in any business plan and helps you calculate your net income for that same period. The most basic use of your income statement is to tell you if your business is profitable or not. 

Depending on the complexity and size of your business, you may find that your statement is fairly simple. But as your business grows, and you add more expenses, revenue streams, and other line items, it can become more complex. Generally, this is what you can expect to find on your income statement.

• Revenue or sales — The amount of money a business takes in 
• Cost of goods sold (COGS) — The cost of what it takes to produce whatever a business sells
• Gross profit — Total revenue minus COGS
• Expenses — The amount of money a business spends
• Earnings before tax — Operating income minus non-operating expenses
• Taxes — Total tax expense
• Net earnings — Income before taxes minus taxes

What is the purpose of an income statement?

The purpose of an income statement is to display your financial performance over a given period. It’s the current snapshot of your actual business performance and it helps you define what occurred in a given day, week, month, and year. 

Now, the true benefit of reviewing your income statement comes with comparing it to other financial documents. Looking between your cash flow statement and balance sheet, for example, can help you determine if your business is truly profitable, if you’re overspending and if you have a healthy level of cash to invest in your business.

Additionally, you want to leverage your income statement to understand if you’re performing better, worse or as expected. This is done by comparing it to your sales and expense forecasts through a review process known as plan vs actuals comparison. You then update projections to match actual performance to better showcase how your business will net out moving forward.

In short, you use your income statement to fuel a greater analysis of the financial standing of your business. It helps you identify any top-level issues or opportunities that you can then dive into with forecast scenarios and by looking at elements of your other financial documentation.

How do you analyze an income statement?

Your income statement is a great place to start your financial review meeting. Conducting an income statement analysis will help you answer key questions about your business, find opportunities for growth, and uncover potential problems before they have a significant impact on your business. 

Here are 4-steps you can take to ensure each review is successful.

1. Check your bottom line

To kick off your review, look to the bottom of your statement. The number there gives you an idea of how your business performed during a specific period. 

Typically, you want to see a positive number, meaning that you earned more than you spent. But if that bottom line is negative, that tells you what the focus of your review should be. You need to find out why you’re in the red and develop a plan for turning it around.

Keep in mind that a net loss once in a while does not necessarily imply disaster. Typically if you’re a new company or experiencing rapid periods of growth, you can expect a lot of upfront costs. Making it unlikely that you’ll turn a profit for a few quarters to a few years. This can also occur if your business is seasonal or cyclical.

You just don’t want net losses to become a trend. If they do, you’ll want to consistently review your cash flow statement to be sure you have enough of a runway to keep your business operational. 

2. Check your sources of income and expense categories

With your current bottom line in mind, it’s time to dive into the categories within your income statement. Specifically, your income streams and expenses. Starting with income, ask yourself the following questions.

• Do they make sense for the business? 
• Are they sustainable? 
• Has it grown gradually over each period? Or is revenue this period higher than usual?
• Is every revenue stream sustainable? Or are there unique line items this period?

Make sure you understand why your business performed the way it did. What events may have increased or decreased revenue and if that will continue over time. Now dive into the associated expenses.

Are they logical? For most businesses, you will see salaries and wages, insurance, rent, supplies, interest, and at least a few other things. Is anything missing that you would expect to see? Are there any specific costs associated with individual lines of revenue?

Like your revenue, try to uncover what leads to specific expenses and where you can work on reducing them. Again, you will likely have times where your expenses are higher than normal. But if they’re consistently rising while your revenue is stagnant or falling, you need to take a closer look at what and why your spending over the next period.

3. Compare your numbers

It was mentioned before, but part of your analysis is comparing results to the last month, quarter, and/or year.  Usually, your income statement will have separate columns showing figures for these prior periods. If the document doesn’t already show the percentage change in every category, you’ll need to calculate those numbers yourself. 

Connect results to projects, teams, or events that drove up revenue or reduced expenses. Question any significant changes. And then look ahead to what the next steps are based on those results and if any adjustments should be made.

Also, be sure to keep in mind why your business was performing the way it was during those previous periods. A dramatic uptick now may be due to poor performance at the same time last year. Not bringing that up can inflate your current results to appear incredibly positive. Meaning you’re still sustainable, but not improving like you could or should be.

4. Review your math

If you’re working off of a manual Excel sheet to build and review your income statement, you’ll want to double-check your math. Adding in numbers, changing algorithms, deleting cells can all lead to mistakes that affect your bottom line. If you can, review your previous period first to refamiliarize yourself with the statement and confirm it’s accurate.

Then move onto creating or updating your current period.If maintaining accuracy on your current statement takes up too much time, you may want to consider using a planning tool like LivePlan . LivePlan makes it easy to review your financials because it pulls in real-time data from your cloud accounting tool like QuickBooks or Xero . It’s seamless to compare actuals against your forecast .

Questions to answer during your income statement analysis

Here are a few of the key questions that you’ll answer when you review your profit and loss statement.

Did we have good sales last month?

It’s easiest to start your review at the top of the profit and loss and work your way down. At the top, you’ll find revenue, and that’s a great place to start.

When you look at your revenue from last month, you should compare it to three other numbers:

• Planned goal for revenue
• Revenue from last month
• Revenue from the same month last year

You’ll want to see if you met your goal for revenue and then answer the question, “why or why not?” If you beat your sales goal, you should discuss what worked better than expected. Are there successes that can be repeated? If you didn’t meet your goal, what prevented you from meeting your goal?

How did our sales compare to the previous month and year?

Ask the same questions about your sales compared to the previous month and the same month last year. A decline from the previous month might be fine if your business has normal seasonality. Most businesses will be looking to grow year-over-year, so comparing your sales to how you did in the same month last year is usually a good measure of your long-term success.

Now, look ahead at your plan for the coming months and decide if you should revise your strategy going forward. Set new goals based on what you achieved during the past month.

Did we spend more than planned?

Now it’s time to look at your expenses—both your cost of goods sold (COGS) and your operational expenses. 

Similar to revenue, you should compare your expenses to your plan, last month, and the same month last year. 

The questions you ask are also similar: are you staying on budget? Are expenses growing or shrinking? Are these changes O.K.? For example, if your sales are growing faster than planned, it’s likely that your expenses are also growing. This is probably fine, but worth keeping track of.

Like you did with revenue, consider your strategy, and plan going forward. Should you adjust your budget or keep things as they are? Set a task for yourself to revise if needed and then share that updated plan with anyone who is spending money in your business so that they can stay on track too.

Did our margins change?

After you’ve reviewed your expenses, take a few minutes to look at your gross margin . Your gross margin measures how much of each sale goes toward the cost of the products and services that you sell, otherwise known as the cost of goods sold.

If this number is shrinking, it means that your costs are going up and eating into your profits. Your overall costs could be going up because you are selling more of a product that costs you more to make or procure. Or maybe your suppliers are charging you more. Either way, if this number is growing, you’ll want to dig into the reasons why and take action.

If your gross margin is growing, congratulations! Your business is becoming more efficient and delivering more profit to the bottom line.

How profitable is our business?

This is the proverbial “bottom line” in your business. Again, you’ll want to compare this number to your plan, the previous period, and the same time period last year. 

If you are more or less profitable than planned, you’ll want to dig into the reasons why. Did expenses go up and reduce profitability? Maybe sales declined, but expenses stayed fairly flat which would also reduce profitability. Look at your numbers and figure out why they are changing and come up with an action plan for changes going forward.

I sold more but why didn’t profits go up?

This is always an interesting problem that many businesses have. You sold more than you did last month, but profits stayed the same or perhaps even went down. How is that possible?

The first place to look is your operational expenses. Perhaps you spent more on marketing than you planned or you brought on some new employees and they helped generate additional sales, but not enough to account for the increases in payroll.

If the answer isn’t in your operational expenses, take a look at your cost of goods. It’s common for the answer to a profitability question to be hiding there. 

As I discussed in the question about margins, you’ll want to look and see if your cost of goods and gross margin changed. Perhaps your sales increased because you sold more of a product that has a high cost, while other low-cost products or services didn’t sell as well.

Consider a bike shop as an example. Mountain bikes might have a pretty low margin — the shop only makes a small profit on each sale. On the other hand, the service department is very profitable. Every repair makes a big profit. So, if sales of mountain bikes increase while service revenue remains the same, the bike shop won’t make as much money as it did the previous month.

In this case, the bike shop might want to explore ideas for growing service revenue or perhaps consider increasing the price of its mountain bikes so that they are more profitable.

Make reviewing your income statement a regular occurrence

Doing an income statement analysis — comparing your key numbers to your plan as well as last month and last year — is extremely useful. It helps answer key questions about your business performance and how you can keep growing, building profits that you can reinvest into your business. 

Build the habit of reviewing your budget compared to your actual performance and you will build a stronger, healthier business. Studies actually prove this — they show that goal setting and measuring progress toward those goals greatly increases your chances for success.

A monthly review of your business financials is invaluable and it doesn’t have to take a ton of time if you have the right tools available. Work with your accountant to make sure you can get the reports you need or use a simple tool like LivePlan to automate the entire process. Either way, take the time to look at your numbers so you can grow your business.

*Editor’s Note: This article was originally written in 2019 and updated for 2021.

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Income Statement: Advantages and Disadvantages Essay

The income statement’s advantages are that it gives a generally full impression of the company’s financial situation, including both revenues and expenses, over a period of time, which is called a fiscal period. There are no exclusions of revenue and expenses, as the list includes all and every one of their sources, representing the company’s net income. The reader of the statement will therefore gain full information of how the company functions.

However, the aforementioned reader’s impression is only representable of the company’s usual, day-to-day situation. Because of comprehensive income, which is generally considered unimportant and not dependent on a firm’s performance, being listed separately, the income statement might not include important information during crises. Still, the information separated to the category of comprehensive income may be important as it includes losses from foreign currency translations, and gains or losses on investments. Arya & Nagar (2018) offer to include more information into the statement as special items in a separate category to increase its stewardship value, but this is yet to be implemented widely in practice. While the FASB requires this information to be reported, the fact that it is listed separately makes an opportunity of a stakeholder missing it.

The income statement has other shortcomings, as the firms’ owners sometimes try to manipulate it to their gain. For example, they try to present their earnings as more significant that in reality, because they are the most important aspect of business (Reimers, 2011). Marking debts or securities as available for sale presents an opportunity to evade putting them into the income statement, only classifying them as equity changes comprehensive income (Reimers, 2011). Certain analytical methods such as the vertical analysis pay too much attention to sales as well (Reimers, 2011). With such a tendency, I consider it possible that comprehensive income may be ignored, while it may include important data on results of critical situations such as international conflicts or large failed investments.

Arya, A., & Nagar, N. (2018). Stewardship Value of Income Statement Classifications: An Empirical Examination . Journal of Accounting, Auditing &Amp; Finance , 36 (1), 56–80. Web.

Reimers, J.L. (2011). Financial Accounting: A Business Process Approach (3rd ed). Pearson.

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IvyPanda. (2024, March 29). Income Statement: Advantages and Disadvantages. https://ivypanda.com/essays/income-statement-advantages-and-disadvantages/

"Income Statement: Advantages and Disadvantages." IvyPanda , 29 Mar. 2024, ivypanda.com/essays/income-statement-advantages-and-disadvantages/.

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IvyPanda . 2024. "Income Statement: Advantages and Disadvantages." March 29, 2024. https://ivypanda.com/essays/income-statement-advantages-and-disadvantages/.

1. IvyPanda . "Income Statement: Advantages and Disadvantages." March 29, 2024. https://ivypanda.com/essays/income-statement-advantages-and-disadvantages/.

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Income Statement Analysis

Updated 28 September 2023

Subject Corporations ,  Finance

Downloads 43

Category Business ,  Economics

Topic Company

Q. Does the firm need to borrow money at the end of the year to meet expenses? Why or why not?

A. Yes, the firm needs to borrow money at the end of the year as it is going in net loss and it will be difficult for it to meet its expenses while running in loss situation. The money to be borrowed is needed due to the following reasons:

Firstly, the firm is already in debts as it is paying monthly interest of 15,000$ on loan notes so it must be considered that further loan taking may also lead to insolvency. If the stakeholders are confident that the loan may result in the recovery of firms’ losses, only then loan should be taken.

Second observation is that the firm is suffering net losses in the last three months of 12,450 $ which means its equity is being used up to meet its expenses. To overcome the situation, and to stop equity from being eaten up by the firms’ daily expenses, the firm must raise loan from any institution so it may recover its expenses.

Further if we analyze the income statement, we observe that 48% of total revenue is being used in wages and salaries but surprisingly the firm is in losses. It is an indication that a layer of idol workers is present that needs to be put to work or fired as they are evidently not adding any value to the company. If the firm is not able tackle that situation properly, it may lead to bankruptcy in future.

*For detailed Income Statement analysis please follow the link:

Unit_10.ans.xlsx

Cook, C. Forecasting financial Requirements [PowerPoint slides].

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• Published: 17 April 2024

The economic commitment of climate change

• Maximilian Kotz   ORCID: orcid.org/0000-0003-2564-5043 1 , 2 ,
• Anders Levermann   ORCID: orcid.org/0000-0003-4432-4704 1 , 2 &
• Leonie Wenz   ORCID: orcid.org/0000-0002-8500-1568 1 , 3  

Nature volume  628 ,  pages 551–557 ( 2024 ) Cite this article

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• Environmental economics
• Environmental health
• Interdisciplinary studies
• Projection and prediction

Global projections of macroeconomic climate-change damages typically consider impacts from average annual and national temperatures over long time horizons 1 , 2 , 3 , 4 , 5 , 6 . Here we use recent empirical findings from more than 1,600 regions worldwide over the past 40 years to project sub-national damages from temperature and precipitation, including daily variability and extremes 7 , 8 . Using an empirical approach that provides a robust lower bound on the persistence of impacts on economic growth, we find that the world economy is committed to an income reduction of 19% within the next 26 years independent of future emission choices (relative to a baseline without climate impacts, likely range of 11–29% accounting for physical climate and empirical uncertainty). These damages already outweigh the mitigation costs required to limit global warming to 2 °C by sixfold over this near-term time frame and thereafter diverge strongly dependent on emission choices. Committed damages arise predominantly through changes in average temperature, but accounting for further climatic components raises estimates by approximately 50% and leads to stronger regional heterogeneity. Committed losses are projected for all regions except those at very high latitudes, at which reductions in temperature variability bring benefits. The largest losses are committed at lower latitudes in regions with lower cumulative historical emissions and lower present-day income.

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Projections of the macroeconomic damage caused by future climate change are crucial to informing public and policy debates about adaptation, mitigation and climate justice. On the one hand, adaptation against climate impacts must be justified and planned on the basis of an understanding of their future magnitude and spatial distribution 9 . This is also of importance in the context of climate justice 10 , as well as to key societal actors, including governments, central banks and private businesses, which increasingly require the inclusion of climate risks in their macroeconomic forecasts to aid adaptive decision-making 11 , 12 . On the other hand, climate mitigation policy such as the Paris Climate Agreement is often evaluated by balancing the costs of its implementation against the benefits of avoiding projected physical damages. This evaluation occurs both formally through cost–benefit analyses 1 , 4 , 5 , 6 , as well as informally through public perception of mitigation and damage costs 13 .

Projections of future damages meet challenges when informing these debates, in particular the human biases relating to uncertainty and remoteness that are raised by long-term perspectives 14 . Here we aim to overcome such challenges by assessing the extent of economic damages from climate change to which the world is already committed by historical emissions and socio-economic inertia (the range of future emission scenarios that are considered socio-economically plausible 15 ). Such a focus on the near term limits the large uncertainties about diverging future emission trajectories, the resulting long-term climate response and the validity of applying historically observed climate–economic relations over long timescales during which socio-technical conditions may change considerably. As such, this focus aims to simplify the communication and maximize the credibility of projected economic damages from future climate change.

In projecting the future economic damages from climate change, we make use of recent advances in climate econometrics that provide evidence for impacts on sub-national economic growth from numerous components of the distribution of daily temperature and precipitation 3 , 7 , 8 . Using fixed-effects panel regression models to control for potential confounders, these studies exploit within-region variation in local temperature and precipitation in a panel of more than 1,600 regions worldwide, comprising climate and income data over the past 40 years, to identify the plausibly causal effects of changes in several climate variables on economic productivity 16 , 17 . Specifically, macroeconomic impacts have been identified from changing daily temperature variability, total annual precipitation, the annual number of wet days and extreme daily rainfall that occur in addition to those already identified from changing average temperature 2 , 3 , 18 . Moreover, regional heterogeneity in these effects based on the prevailing local climatic conditions has been found using interactions terms. The selection of these climate variables follows micro-level evidence for mechanisms related to the impacts of average temperatures on labour and agricultural productivity 2 , of temperature variability on agricultural productivity and health 7 , as well as of precipitation on agricultural productivity, labour outcomes and flood damages 8 (see Extended Data Table 1 for an overview, including more detailed references). References  7 , 8 contain a more detailed motivation for the use of these particular climate variables and provide extensive empirical tests about the robustness and nature of their effects on economic output, which are summarized in Methods . By accounting for these extra climatic variables at the sub-national level, we aim for a more comprehensive description of climate impacts with greater detail across both time and space.

Constraining the persistence of impacts

A key determinant and source of discrepancy in estimates of the magnitude of future climate damages is the extent to which the impact of a climate variable on economic growth rates persists. The two extreme cases in which these impacts persist indefinitely or only instantaneously are commonly referred to as growth or level effects 19 , 20 (see Methods section ‘Empirical model specification: fixed-effects distributed lag models’ for mathematical definitions). Recent work shows that future damages from climate change depend strongly on whether growth or level effects are assumed 20 . Following refs.  2 , 18 , we provide constraints on this persistence by using distributed lag models to test the significance of delayed effects separately for each climate variable. Notably, and in contrast to refs.  2 , 18 , we use climate variables in their first-differenced form following ref.  3 , implying a dependence of the growth rate on a change in climate variables. This choice means that a baseline specification without any lags constitutes a model prior of purely level effects, in which a permanent change in the climate has only an instantaneous effect on the growth rate 3 , 19 , 21 . By including lags, one can then test whether any effects may persist further. This is in contrast to the specification used by refs.  2 , 18 , in which climate variables are used without taking the first difference, implying a dependence of the growth rate on the level of climate variables. In this alternative case, the baseline specification without any lags constitutes a model prior of pure growth effects, in which a change in climate has an infinitely persistent effect on the growth rate. Consequently, including further lags in this alternative case tests whether the initial growth impact is recovered 18 , 19 , 21 . Both of these specifications suffer from the limiting possibility that, if too few lags are included, one might falsely accept the model prior. The limitations of including a very large number of lags, including loss of data and increasing statistical uncertainty with an increasing number of parameters, mean that such a possibility is likely. By choosing a specification in which the model prior is one of level effects, our approach is therefore conservative by design, avoiding assumptions of infinite persistence of climate impacts on growth and instead providing a lower bound on this persistence based on what is observable empirically (see Methods section ‘Empirical model specification: fixed-effects distributed lag models’ for further exposition of this framework). The conservative nature of such a choice is probably the reason that ref.  19 finds much greater consistency between the impacts projected by models that use the first difference of climate variables, as opposed to their levels.

We begin our empirical analysis of the persistence of climate impacts on growth using ten lags of the first-differenced climate variables in fixed-effects distributed lag models. We detect substantial effects on economic growth at time lags of up to approximately 8–10 years for the temperature terms and up to approximately 4 years for the precipitation terms (Extended Data Fig. 1 and Extended Data Table 2 ). Furthermore, evaluation by means of information criteria indicates that the inclusion of all five climate variables and the use of these numbers of lags provide a preferable trade-off between best-fitting the data and including further terms that could cause overfitting, in comparison with model specifications excluding climate variables or including more or fewer lags (Extended Data Fig. 3 , Supplementary Methods Section  1 and Supplementary Table 1 ). We therefore remove statistically insignificant terms at later lags (Supplementary Figs. 1 – 3 and Supplementary Tables 2 – 4 ). Further tests using Monte Carlo simulations demonstrate that the empirical models are robust to autocorrelation in the lagged climate variables (Supplementary Methods Section  2 and Supplementary Figs. 4 and 5 ), that information criteria provide an effective indicator for lag selection (Supplementary Methods Section  2 and Supplementary Fig. 6 ), that the results are robust to concerns of imperfect multicollinearity between climate variables and that including several climate variables is actually necessary to isolate their separate effects (Supplementary Methods Section  3 and Supplementary Fig. 7 ). We provide a further robustness check using a restricted distributed lag model to limit oscillations in the lagged parameter estimates that may result from autocorrelation, finding that it provides similar estimates of cumulative marginal effects to the unrestricted model (Supplementary Methods Section 4 and Supplementary Figs. 8 and 9 ). Finally, to explicitly account for any outstanding uncertainty arising from the precise choice of the number of lags, we include empirical models with marginally different numbers of lags in the error-sampling procedure of our projection of future damages. On the basis of the lag-selection procedure (the significance of lagged terms in Extended Data Fig. 1 and Extended Data Table 2 , as well as information criteria in Extended Data Fig. 3 ), we sample from models with eight to ten lags for temperature and four for precipitation (models shown in Supplementary Figs. 1 – 3 and Supplementary Tables 2 – 4 ). In summary, this empirical approach to constrain the persistence of climate impacts on economic growth rates is conservative by design in avoiding assumptions of infinite persistence, but nevertheless provides a lower bound on the extent of impact persistence that is robust to the numerous tests outlined above.

Committed damages until mid-century

We combine these empirical economic response functions (Supplementary Figs. 1 – 3 and Supplementary Tables 2 – 4 ) with an ensemble of 21 climate models (see Supplementary Table 5 ) from the Coupled Model Intercomparison Project Phase 6 (CMIP-6) 22 to project the macroeconomic damages from these components of physical climate change (see Methods for further details). Bias-adjusted climate models that provide a highly accurate reproduction of observed climatological patterns with limited uncertainty (Supplementary Table 6 ) are used to avoid introducing biases in the projections. Following a well-developed literature 2 , 3 , 19 , these projections do not aim to provide a prediction of future economic growth. Instead, they are a projection of the exogenous impact of future climate conditions on the economy relative to the baselines specified by socio-economic projections, based on the plausibly causal relationships inferred by the empirical models and assuming ceteris paribus. Other exogenous factors relevant for the prediction of economic output are purposefully assumed constant.

A Monte Carlo procedure that samples from climate model projections, empirical models with different numbers of lags and model parameter estimates (obtained by 1,000 block-bootstrap resamples of each of the regressions in Supplementary Figs. 1 – 3 and Supplementary Tables 2 – 4 ) is used to estimate the combined uncertainty from these sources. Given these uncertainty distributions, we find that projected global damages are statistically indistinguishable across the two most extreme emission scenarios until 2049 (at the 5% significance level; Fig. 1 ). As such, the climate damages occurring before this time constitute those to which the world is already committed owing to the combination of past emissions and the range of future emission scenarios that are considered socio-economically plausible 15 . These committed damages comprise a permanent income reduction of 19% on average globally (population-weighted average) in comparison with a baseline without climate-change impacts (with a likely range of 11–29%, following the likelihood classification adopted by the Intergovernmental Panel on Climate Change (IPCC); see caption of Fig. 1 ). Even though levels of income per capita generally still increase relative to those of today, this constitutes a permanent income reduction for most regions, including North America and Europe (each with median income reductions of approximately 11%) and with South Asia and Africa being the most strongly affected (each with median income reductions of approximately 22%; Fig. 1 ). Under a middle-of-the road scenario of future income development (SSP2, in which SSP stands for Shared Socio-economic Pathway), this corresponds to global annual damages in 2049 of 38 trillion in 2005 international dollars (likely range of 19–59 trillion 2005 international dollars). Compared with empirical specifications that assume pure growth or pure level effects, our preferred specification that provides a robust lower bound on the extent of climate impact persistence produces damages between these two extreme assumptions (Extended Data Fig. 3 ).

Estimates of the projected reduction in income per capita from changes in all climate variables based on empirical models of climate impacts on economic output with a robust lower bound on their persistence (Extended Data Fig. 1 ) under a low-emission scenario compatible with the 2 °C warming target and a high-emission scenario (SSP2-RCP2.6 and SSP5-RCP8.5, respectively) are shown in purple and orange, respectively. Shading represents the 34% and 10% confidence intervals reflecting the likely and very likely ranges, respectively (following the likelihood classification adopted by the IPCC), having estimated uncertainty from a Monte Carlo procedure, which samples the uncertainty from the choice of physical climate models, empirical models with different numbers of lags and bootstrapped estimates of the regression parameters shown in Supplementary Figs. 1 – 3 . Vertical dashed lines show the time at which the climate damages of the two emission scenarios diverge at the 5% and 1% significance levels based on the distribution of differences between emission scenarios arising from the uncertainty sampling discussed above. Note that uncertainty in the difference of the two scenarios is smaller than the combined uncertainty of the two respective scenarios because samples of the uncertainty (climate model and empirical model choice, as well as model parameter bootstrap) are consistent across the two emission scenarios, hence the divergence of damages occurs while the uncertainty bounds of the two separate damage scenarios still overlap. Estimates of global mitigation costs from the three IAMs that provide results for the SSP2 baseline and SSP2-RCP2.6 scenario are shown in light green in the top panel, with the median of these estimates shown in bold.

Damages already outweigh mitigation costs

We compare the damages to which the world is committed over the next 25 years to estimates of the mitigation costs required to achieve the Paris Climate Agreement. Taking estimates of mitigation costs from the three integrated assessment models (IAMs) in the IPCC AR6 database 23 that provide results under comparable scenarios (SSP2 baseline and SSP2-RCP2.6, in which RCP stands for Representative Concentration Pathway), we find that the median committed climate damages are larger than the median mitigation costs in 2050 (six trillion in 2005 international dollars) by a factor of approximately six (note that estimates of mitigation costs are only provided every 10 years by the IAMs and so a comparison in 2049 is not possible). This comparison simply aims to compare the magnitude of future damages against mitigation costs, rather than to conduct a formal cost–benefit analysis of transitioning from one emission path to another. Formal cost–benefit analyses typically find that the net benefits of mitigation only emerge after 2050 (ref.  5 ), which may lead some to conclude that physical damages from climate change are simply not large enough to outweigh mitigation costs until the second half of the century. Our simple comparison of their magnitudes makes clear that damages are actually already considerably larger than mitigation costs and the delayed emergence of net mitigation benefits results primarily from the fact that damages across different emission paths are indistinguishable until mid-century (Fig. 1 ).

Although these near-term damages constitute those to which the world is already committed, we note that damage estimates diverge strongly across emission scenarios after 2049, conveying the clear benefits of mitigation from a purely economic point of view that have been emphasized in previous studies 4 , 24 . As well as the uncertainties assessed in Fig. 1 , these conclusions are robust to structural choices, such as the timescale with which changes in the moderating variables of the empirical models are estimated (Supplementary Figs. 10 and 11 ), as well as the order in which one accounts for the intertemporal and international components of currency comparison (Supplementary Fig. 12 ; see Methods for further details).

Damages from variability and extremes

Committed damages primarily arise through changes in average temperature (Fig. 2 ). This reflects the fact that projected changes in average temperature are larger than those in other climate variables when expressed as a function of their historical interannual variability (Extended Data Fig. 4 ). Because the historical variability is that on which the empirical models are estimated, larger projected changes in comparison with this variability probably lead to larger future impacts in a purely statistical sense. From a mechanistic perspective, one may plausibly interpret this result as implying that future changes in average temperature are the most unprecedented from the perspective of the historical fluctuations to which the economy is accustomed and therefore will cause the most damage. This insight may prove useful in terms of guiding adaptation measures to the sources of greatest damage.

Estimates of the median projected reduction in sub-national income per capita across emission scenarios (SSP2-RCP2.6 and SSP2-RCP8.5) as well as climate model, empirical model and model parameter uncertainty in the year in which climate damages diverge at the 5% level (2049, as identified in Fig. 1 ). a , Impacts arising from all climate variables. b – f , Impacts arising separately from changes in annual mean temperature ( b ), daily temperature variability ( c ), total annual precipitation ( d ), the annual number of wet days (>1 mm) ( e ) and extreme daily rainfall ( f ) (see Methods for further definitions). Data on national administrative boundaries are obtained from the GADM database version 3.6 and are freely available for academic use ( https://gadm.org/ ).

Nevertheless, future damages based on empirical models that consider changes in annual average temperature only and exclude the other climate variables constitute income reductions of only 13% in 2049 (Extended Data Fig. 5a , likely range 5–21%). This suggests that accounting for the other components of the distribution of temperature and precipitation raises net damages by nearly 50%. This increase arises through the further damages that these climatic components cause, but also because their inclusion reveals a stronger negative economic response to average temperatures (Extended Data Fig. 5b ). The latter finding is consistent with our Monte Carlo simulations, which suggest that the magnitude of the effect of average temperature on economic growth is underestimated unless accounting for the impacts of other correlated climate variables (Supplementary Fig. 7 ).

In terms of the relative contributions of the different climatic components to overall damages, we find that accounting for daily temperature variability causes the largest increase in overall damages relative to empirical frameworks that only consider changes in annual average temperature (4.9 percentage points, likely range 2.4–8.7 percentage points, equivalent to approximately 10 trillion international dollars). Accounting for precipitation causes smaller increases in overall damages, which are—nevertheless—equivalent to approximately 1.2 trillion international dollars: 0.01 percentage points (−0.37–0.33 percentage points), 0.34 percentage points (0.07–0.90 percentage points) and 0.36 percentage points (0.13–0.65 percentage points) from total annual precipitation, the number of wet days and extreme daily precipitation, respectively. Moreover, climate models seem to underestimate future changes in temperature variability 25 and extreme precipitation 26 , 27 in response to anthropogenic forcing as compared with that observed historically, suggesting that the true impacts from these variables may be larger.

The distribution of committed damages

The spatial distribution of committed damages (Fig. 2a ) reflects a complex interplay between the patterns of future change in several climatic components and those of historical economic vulnerability to changes in those variables. Damages resulting from increasing annual mean temperature (Fig. 2b ) are negative almost everywhere globally, and larger at lower latitudes in regions in which temperatures are already higher and economic vulnerability to temperature increases is greatest (see the response heterogeneity to mean temperature embodied in Extended Data Fig. 1a ). This occurs despite the amplified warming projected at higher latitudes 28 , suggesting that regional heterogeneity in economic vulnerability to temperature changes outweighs heterogeneity in the magnitude of future warming (Supplementary Fig. 13a ). Economic damages owing to daily temperature variability (Fig. 2c ) exhibit a strong latitudinal polarisation, primarily reflecting the physical response of daily variability to greenhouse forcing in which increases in variability across lower latitudes (and Europe) contrast decreases at high latitudes 25 (Supplementary Fig. 13b ). These two temperature terms are the dominant determinants of the pattern of overall damages (Fig. 2a ), which exhibits a strong polarity with damages across most of the globe except at the highest northern latitudes. Future changes in total annual precipitation mainly bring economic benefits except in regions of drying, such as the Mediterranean and central South America (Fig. 2d and Supplementary Fig. 13c ), but these benefits are opposed by changes in the number of wet days, which produce damages with a similar pattern of opposite sign (Fig. 2e and Supplementary Fig. 13d ). By contrast, changes in extreme daily rainfall produce damages in all regions, reflecting the intensification of daily rainfall extremes over global land areas 29 , 30 (Fig. 2f and Supplementary Fig. 13e ).

The spatial distribution of committed damages implies considerable injustice along two dimensions: culpability for the historical emissions that have caused climate change and pre-existing levels of socio-economic welfare. Spearman’s rank correlations indicate that committed damages are significantly larger in countries with smaller historical cumulative emissions, as well as in regions with lower current income per capita (Fig. 3 ). This implies that those countries that will suffer the most from the damages already committed are those that are least responsible for climate change and which also have the least resources to adapt to it.

Estimates of the median projected change in national income per capita across emission scenarios (RCP2.6 and RCP8.5) as well as climate model, empirical model and model parameter uncertainty in the year in which climate damages diverge at the 5% level (2049, as identified in Fig. 1 ) are plotted against cumulative national emissions per capita in 2020 (from the Global Carbon Project) and coloured by national income per capita in 2020 (from the World Bank) in a and vice versa in b . In each panel, the size of each scatter point is weighted by the national population in 2020 (from the World Bank). Inset numbers indicate the Spearman’s rank correlation ρ and P -values for a hypothesis test whose null hypothesis is of no correlation, as well as the Spearman’s rank correlation weighted by national population.

To further quantify this heterogeneity, we assess the difference in committed damages between the upper and lower quartiles of regions when ranked by present income levels and historical cumulative emissions (using a population weighting to both define the quartiles and estimate the group averages). On average, the quartile of countries with lower income are committed to an income loss that is 8.9 percentage points (or 61%) greater than the upper quartile (Extended Data Fig. 6 ), with a likely range of 3.8–14.7 percentage points across the uncertainty sampling of our damage projections (following the likelihood classification adopted by the IPCC). Similarly, the quartile of countries with lower historical cumulative emissions are committed to an income loss that is 6.9 percentage points (or 40%) greater than the upper quartile, with a likely range of 0.27–12 percentage points. These patterns reemphasize the prevalence of injustice in climate impacts 31 , 32 , 33 in the context of the damages to which the world is already committed by historical emissions and socio-economic inertia.

Contextualizing the magnitude of damages

The magnitude of projected economic damages exceeds previous literature estimates 2 , 3 , arising from several developments made on previous approaches. Our estimates are larger than those of ref.  2 (see first row of Extended Data Table 3 ), primarily because of the facts that sub-national estimates typically show a steeper temperature response (see also refs.  3 , 34 ) and that accounting for other climatic components raises damage estimates (Extended Data Fig. 5 ). However, we note that our empirical approach using first-differenced climate variables is conservative compared with that of ref.  2 in regard to the persistence of climate impacts on growth (see introduction and Methods section ‘Empirical model specification: fixed-effects distributed lag models’), an important determinant of the magnitude of long-term damages 19 , 21 . Using a similar empirical specification to ref.  2 , which assumes infinite persistence while maintaining the rest of our approach (sub-national data and further climate variables), produces considerably larger damages (purple curve of Extended Data Fig. 3 ). Compared with studies that do take the first difference of climate variables 3 , 35 , our estimates are also larger (see second and third rows of Extended Data Table 3 ). The inclusion of further climate variables (Extended Data Fig. 5 ) and a sufficient number of lags to more adequately capture the extent of impact persistence (Extended Data Figs. 1 and 2 ) are the main sources of this difference, as is the use of specifications that capture nonlinearities in the temperature response when compared with ref.  35 . In summary, our estimates develop on previous studies by incorporating the latest data and empirical insights 7 , 8 , as well as in providing a robust empirical lower bound on the persistence of impacts on economic growth, which constitutes a middle ground between the extremes of the growth-versus-levels debate 19 , 21 (Extended Data Fig. 3 ).

Compared with the fraction of variance explained by the empirical models historically (<5%), the projection of reductions in income of 19% may seem large. This arises owing to the fact that projected changes in climatic conditions are much larger than those that were experienced historically, particularly for changes in average temperature (Extended Data Fig. 4 ). As such, any assessment of future climate-change impacts necessarily requires an extrapolation outside the range of the historical data on which the empirical impact models were evaluated. Nevertheless, these models constitute the most state-of-the-art methods for inference of plausibly causal climate impacts based on observed data. Moreover, we take explicit steps to limit out-of-sample extrapolation by capping the moderating variables of the interaction terms at the 95th percentile of the historical distribution (see Methods ). This avoids extrapolating the marginal effects outside what was observed historically. Given the nonlinear response of economic output to annual mean temperature (Extended Data Fig. 1 and Extended Data Table 2 ), this is a conservative choice that limits the magnitude of damages that we project. Furthermore, back-of-the-envelope calculations indicate that the projected damages are consistent with the magnitude and patterns of historical economic development (see Supplementary Discussion Section  5 ).

Missing impacts and spatial spillovers

Despite assessing several climatic components from which economic impacts have recently been identified 3 , 7 , 8 , this assessment of aggregate climate damages should not be considered comprehensive. Important channels such as impacts from heatwaves 31 , sea-level rise 36 , tropical cyclones 37 and tipping points 38 , 39 , as well as non-market damages such as those to ecosystems 40 and human health 41 , are not considered in these estimates. Sea-level rise is unlikely to be feasibly incorporated into empirical assessments such as this because historical sea-level variability is mostly small. Non-market damages are inherently intractable within our estimates of impacts on aggregate monetary output and estimates of these impacts could arguably be considered as extra to those identified here. Recent empirical work suggests that accounting for these channels would probably raise estimates of these committed damages, with larger damages continuing to arise in the global south 31 , 36 , 37 , 38 , 39 , 40 , 41 , 42 .

Moreover, our main empirical analysis does not explicitly evaluate the potential for impacts in local regions to produce effects that ‘spill over’ into other regions. Such effects may further mitigate or amplify the impacts we estimate, for example, if companies relocate production from one affected region to another or if impacts propagate along supply chains. The current literature indicates that trade plays a substantial role in propagating spillover effects 43 , 44 , making their assessment at the sub-national level challenging without available data on sub-national trade dependencies. Studies accounting for only spatially adjacent neighbours indicate that negative impacts in one region induce further negative impacts in neighbouring regions 45 , 46 , 47 , 48 , suggesting that our projected damages are probably conservative by excluding these effects. In Supplementary Fig. 14 , we assess spillovers from neighbouring regions using a spatial-lag model. For simplicity, this analysis excludes temporal lags, focusing only on contemporaneous effects. The results show that accounting for spatial spillovers can amplify the overall magnitude, and also the heterogeneity, of impacts. Consistent with previous literature, this indicates that the overall magnitude (Fig. 1 ) and heterogeneity (Fig. 3 ) of damages that we project in our main specification may be conservative without explicitly accounting for spillovers. We note that further analysis that addresses both spatially and trade-connected spillovers, while also accounting for delayed impacts using temporal lags, would be necessary to adequately address this question fully. These approaches offer fruitful avenues for further research but are beyond the scope of this manuscript, which primarily aims to explore the impacts of different climate conditions and their persistence.

Policy implications

We find that the economic damages resulting from climate change until 2049 are those to which the world economy is already committed and that these greatly outweigh the costs required to mitigate emissions in line with the 2 °C target of the Paris Climate Agreement (Fig. 1 ). This assessment is complementary to formal analyses of the net costs and benefits associated with moving from one emission path to another, which typically find that net benefits of mitigation only emerge in the second half of the century 5 . Our simple comparison of the magnitude of damages and mitigation costs makes clear that this is primarily because damages are indistinguishable across emissions scenarios—that is, committed—until mid-century (Fig. 1 ) and that they are actually already much larger than mitigation costs. For simplicity, and owing to the availability of data, we compare damages to mitigation costs at the global level. Regional estimates of mitigation costs may shed further light on the national incentives for mitigation to which our results already hint, of relevance for international climate policy. Although these damages are committed from a mitigation perspective, adaptation may provide an opportunity to reduce them. Moreover, the strong divergence of damages after mid-century reemphasizes the clear benefits of mitigation from a purely economic perspective, as highlighted in previous studies 1 , 4 , 6 , 24 .

Historical climate data

Historical daily 2-m temperature and precipitation totals (in mm) are obtained for the period 1979–2019 from the W5E5 database. The W5E5 dataset comes from ERA-5, a state-of-the-art reanalysis of historical observations, but has been bias-adjusted by applying version 2.0 of the WATCH Forcing Data to ERA-5 reanalysis data and precipitation data from version 2.3 of the Global Precipitation Climatology Project to better reflect ground-based measurements 49 , 50 , 51 . We obtain these data on a 0.5° × 0.5° grid from the Inter-Sectoral Impact Model Intercomparison Project (ISIMIP) database. Notably, these historical data have been used to bias-adjust future climate projections from CMIP-6 (see the following section), ensuring consistency between the distribution of historical daily weather on which our empirical models were estimated and the climate projections used to estimate future damages. These data are publicly available from the ISIMIP database. See refs.  7 , 8 for robustness tests of the empirical models to the choice of climate data reanalysis products.

Future climate data

Daily 2-m temperature and precipitation totals (in mm) are taken from 21 climate models participating in CMIP-6 under a high (RCP8.5) and a low (RCP2.6) greenhouse gas emission scenario from 2015 to 2100. The data have been bias-adjusted and statistically downscaled to a common half-degree grid to reflect the historical distribution of daily temperature and precipitation of the W5E5 dataset using the trend-preserving method developed by the ISIMIP 50 , 52 . As such, the climate model data reproduce observed climatological patterns exceptionally well (Supplementary Table 5 ). Gridded data are publicly available from the ISIMIP database.

Historical economic data

Historical economic data come from the DOSE database of sub-national economic output 53 . We use a recent revision to the DOSE dataset that provides data across 83 countries, 1,660 sub-national regions with varying temporal coverage from 1960 to 2019. Sub-national units constitute the first administrative division below national, for example, states for the USA and provinces for China. Data come from measures of gross regional product per capita (GRPpc) or income per capita in local currencies, reflecting the values reported in national statistical agencies, yearbooks and, in some cases, academic literature. We follow previous literature 3 , 7 , 8 , 54 and assess real sub-national output per capita by first converting values from local currencies to US dollars to account for diverging national inflationary tendencies and then account for US inflation using a US deflator. Alternatively, one might first account for national inflation and then convert between currencies. Supplementary Fig. 12 demonstrates that our conclusions are consistent when accounting for price changes in the reversed order, although the magnitude of estimated damages varies. See the documentation of the DOSE dataset for further discussion of these choices. Conversions between currencies are conducted using exchange rates from the FRED database of the Federal Reserve Bank of St. Louis 55 and the national deflators from the World Bank 56 .

Future socio-economic data

Baseline gridded gross domestic product (GDP) and population data for the period 2015–2100 are taken from the middle-of-the-road scenario SSP2 (ref.  15 ). Population data have been downscaled to a half-degree grid by the ISIMIP following the methodologies of refs.  57 , 58 , which we then aggregate to the sub-national level of our economic data using the spatial aggregation procedure described below. Because current methodologies for downscaling the GDP of the SSPs use downscaled population to do so, per-capita estimates of GDP with a realistic distribution at the sub-national level are not readily available for the SSPs. We therefore use national-level GDP per capita (GDPpc) projections for all sub-national regions of a given country, assuming homogeneity within countries in terms of baseline GDPpc. Here we use projections that have been updated to account for the impact of the COVID-19 pandemic on the trajectory of future income, while remaining consistent with the long-term development of the SSPs 59 . The choice of baseline SSP alters the magnitude of projected climate damages in monetary terms, but when assessed in terms of percentage change from the baseline, the choice of socio-economic scenario is inconsequential. Gridded SSP population data and national-level GDPpc data are publicly available from the ISIMIP database. Sub-national estimates as used in this study are available in the code and data replication files.

Climate variables

Following recent literature 3 , 7 , 8 , we calculate an array of climate variables for which substantial impacts on macroeconomic output have been identified empirically, supported by further evidence at the micro level for plausible underlying mechanisms. See refs.  7 , 8 for an extensive motivation for the use of these particular climate variables and for detailed empirical tests on the nature and robustness of their effects on economic output. To summarize, these studies have found evidence for independent impacts on economic growth rates from annual average temperature, daily temperature variability, total annual precipitation, the annual number of wet days and extreme daily rainfall. Assessments of daily temperature variability were motivated by evidence of impacts on agricultural output and human health, as well as macroeconomic literature on the impacts of volatility on growth when manifest in different dimensions, such as government spending, exchange rates and even output itself 7 . Assessments of precipitation impacts were motivated by evidence of impacts on agricultural productivity, metropolitan labour outcomes and conflict, as well as damages caused by flash flooding 8 . See Extended Data Table 1 for detailed references to empirical studies of these physical mechanisms. Marked impacts of daily temperature variability, total annual precipitation, the number of wet days and extreme daily rainfall on macroeconomic output were identified robustly across different climate datasets, spatial aggregation schemes, specifications of regional time trends and error-clustering approaches. They were also found to be robust to the consideration of temperature extremes 7 , 8 . Furthermore, these climate variables were identified as having independent effects on economic output 7 , 8 , which we further explain here using Monte Carlo simulations to demonstrate the robustness of the results to concerns of imperfect multicollinearity between climate variables (Supplementary Methods Section  2 ), as well as by using information criteria (Supplementary Table 1 ) to demonstrate that including several lagged climate variables provides a preferable trade-off between optimally describing the data and limiting the possibility of overfitting.

We calculate these variables from the distribution of daily, d , temperature, T x , d , and precipitation, P x , d , at the grid-cell, x , level for both the historical and future climate data. As well as annual mean temperature, \({\bar{T}}_{x,y}\) , and annual total precipitation, P x , y , we calculate annual, y , measures of daily temperature variability, \({\widetilde{T}}_{x,y}\) :

the number of wet days, Pwd x , y :

and extreme daily rainfall:

in which T x , d , m , y is the grid-cell-specific daily temperature in month m and year y , \({\bar{T}}_{x,m,{y}}\) is the year and grid-cell-specific monthly, m , mean temperature, D m and D y the number of days in a given month m or year y , respectively, H the Heaviside step function, 1 mm the threshold used to define wet days and P 99.9 x is the 99.9th percentile of historical (1979–2019) daily precipitation at the grid-cell level. Units of the climate measures are degrees Celsius for annual mean temperature and daily temperature variability, millimetres for total annual precipitation and extreme daily precipitation, and simply the number of days for the annual number of wet days.

We also calculated weighted standard deviations of monthly rainfall totals as also used in ref.  8 but do not include them in our projections as we find that, when accounting for delayed effects, their effect becomes statistically indistinct and is better captured by changes in total annual rainfall.

Spatial aggregation

We aggregate grid-cell-level historical and future climate measures, as well as grid-cell-level future GDPpc and population, to the level of the first administrative unit below national level of the GADM database, using an area-weighting algorithm that estimates the portion of each grid cell falling within an administrative boundary. We use this as our baseline specification following previous findings that the effect of area or population weighting at the sub-national level is negligible 7 , 8 .

Empirical model specification: fixed-effects distributed lag models

Following a wide range of climate econometric literature 16 , 60 , we use panel regression models with a selection of fixed effects and time trends to isolate plausibly exogenous variation with which to maximize confidence in a causal interpretation of the effects of climate on economic growth rates. The use of region fixed effects, μ r , accounts for unobserved time-invariant differences between regions, such as prevailing climatic norms and growth rates owing to historical and geopolitical factors. The use of yearly fixed effects, η y , accounts for regionally invariant annual shocks to the global climate or economy such as the El Niño–Southern Oscillation or global recessions. In our baseline specification, we also include region-specific linear time trends, k r y , to exclude the possibility of spurious correlations resulting from common slow-moving trends in climate and growth.

The persistence of climate impacts on economic growth rates is a key determinant of the long-term magnitude of damages. Methods for inferring the extent of persistence in impacts on growth rates have typically used lagged climate variables to evaluate the presence of delayed effects or catch-up dynamics 2 , 18 . For example, consider starting from a model in which a climate condition, C r , y , (for example, annual mean temperature) affects the growth rate, Δlgrp r , y (the first difference of the logarithm of gross regional product) of region r in year y :

which we refer to as a ‘pure growth effects’ model in the main text. Typically, further lags are included,

and the cumulative effect of all lagged terms is evaluated to assess the extent to which climate impacts on growth rates persist. Following ref.  18 , in the case that,

the implication is that impacts on the growth rate persist up to NL years after the initial shock (possibly to a weaker or a stronger extent), whereas if

then the initial impact on the growth rate is recovered after NL years and the effect is only one on the level of output. However, we note that such approaches are limited by the fact that, when including an insufficient number of lags to detect a recovery of the growth rates, one may find equation ( 6 ) to be satisfied and incorrectly assume that a change in climatic conditions affects the growth rate indefinitely. In practice, given a limited record of historical data, including too few lags to confidently conclude in an infinitely persistent impact on the growth rate is likely, particularly over the long timescales over which future climate damages are often projected 2 , 24 . To avoid this issue, we instead begin our analysis with a model for which the level of output, lgrp r , y , depends on the level of a climate variable, C r , y :

Given the non-stationarity of the level of output, we follow the literature 19 and estimate such an equation in first-differenced form as,

which we refer to as a model of ‘pure level effects’ in the main text. This model constitutes a baseline specification in which a permanent change in the climate variable produces an instantaneous impact on the growth rate and a permanent effect only on the level of output. By including lagged variables in this specification,

we are able to test whether the impacts on the growth rate persist any further than instantaneously by evaluating whether α L  > 0 are statistically significantly different from zero. Even though this framework is also limited by the possibility of including too few lags, the choice of a baseline model specification in which impacts on the growth rate do not persist means that, in the case of including too few lags, the framework reverts to the baseline specification of level effects. As such, this framework is conservative with respect to the persistence of impacts and the magnitude of future damages. It naturally avoids assumptions of infinite persistence and we are able to interpret any persistence that we identify with equation ( 9 ) as a lower bound on the extent of climate impact persistence on growth rates. See the main text for further discussion of this specification choice, in particular about its conservative nature compared with previous literature estimates, such as refs.  2 , 18 .

We allow the response to climatic changes to vary across regions, using interactions of the climate variables with historical average (1979–2019) climatic conditions reflecting heterogenous effects identified in previous work 7 , 8 . Following this previous work, the moderating variables of these interaction terms constitute the historical average of either the variable itself or of the seasonal temperature difference, \({\hat{T}}_{r}\) , or annual mean temperature, \({\bar{T}}_{r}\) , in the case of daily temperature variability 7 and extreme daily rainfall, respectively 8 .

The resulting regression equation with N and M lagged variables, respectively, reads:

in which Δlgrp r , y is the annual, regional GRPpc growth rate, measured as the first difference of the logarithm of real GRPpc, following previous work 2 , 3 , 7 , 8 , 18 , 19 . Fixed-effects regressions were run using the fixest package in R (ref.  61 ).

Estimates of the coefficients of interest α i , L are shown in Extended Data Fig. 1 for N  =  M  = 10 lags and for our preferred choice of the number of lags in Supplementary Figs. 1 – 3 . In Extended Data Fig. 1 , errors are shown clustered at the regional level, but for the construction of damage projections, we block-bootstrap the regressions by region 1,000 times to provide a range of parameter estimates with which to sample the projection uncertainty (following refs.  2 , 31 ).

Spatial-lag model

In Supplementary Fig. 14 , we present the results from a spatial-lag model that explores the potential for climate impacts to ‘spill over’ into spatially neighbouring regions. We measure the distance between centroids of each pair of sub-national regions and construct spatial lags that take the average of the first-differenced climate variables and their interaction terms over neighbouring regions that are at distances of 0–500, 500–1,000, 1,000–1,500 and 1,500–2000 km (spatial lags, ‘SL’, 1 to 4). For simplicity, we then assess a spatial-lag model without temporal lags to assess spatial spillovers of contemporaneous climate impacts. This model takes the form:

in which SL indicates the spatial lag of each climate variable and interaction term. In Supplementary Fig. 14 , we plot the cumulative marginal effect of each climate variable at different baseline climate conditions by summing the coefficients for each climate variable and interaction term, for example, for average temperature impacts as:

These cumulative marginal effects can be regarded as the overall spatially dependent impact to an individual region given a one-unit shock to a climate variable in that region and all neighbouring regions at a given value of the moderating variable of the interaction term.

Constructing projections of economic damage from future climate change

We construct projections of future climate damages by applying the coefficients estimated in equation ( 10 ) and shown in Supplementary Tables 2 – 4 (when including only lags with statistically significant effects in specifications that limit overfitting; see Supplementary Methods Section  1 ) to projections of future climate change from the CMIP-6 models. Year-on-year changes in each primary climate variable of interest are calculated to reflect the year-to-year variations used in the empirical models. 30-year moving averages of the moderating variables of the interaction terms are calculated to reflect the long-term average of climatic conditions that were used for the moderating variables in the empirical models. By using moving averages in the projections, we account for the changing vulnerability to climate shocks based on the evolving long-term conditions (Supplementary Figs. 10 and 11 show that the results are robust to the precise choice of the window of this moving average). Although these climate variables are not differenced, the fact that the bias-adjusted climate models reproduce observed climatological patterns across regions for these moderating variables very accurately (Supplementary Table 6 ) with limited spread across models (<3%) precludes the possibility that any considerable bias or uncertainty is introduced by this methodological choice. However, we impose caps on these moderating variables at the 95th percentile at which they were observed in the historical data to prevent extrapolation of the marginal effects outside the range in which the regressions were estimated. This is a conservative choice that limits the magnitude of our damage projections.

Time series of primary climate variables and moderating climate variables are then combined with estimates of the empirical model parameters to evaluate the regression coefficients in equation ( 10 ), producing a time series of annual GRPpc growth-rate reductions for a given emission scenario, climate model and set of empirical model parameters. The resulting time series of growth-rate impacts reflects those occurring owing to future climate change. By contrast, a future scenario with no climate change would be one in which climate variables do not change (other than with random year-to-year fluctuations) and hence the time-averaged evaluation of equation ( 10 ) would be zero. Our approach therefore implicitly compares the future climate-change scenario to this no-climate-change baseline scenario.

The time series of growth-rate impacts owing to future climate change in region r and year y , δ r , y , are then added to the future baseline growth rates, π r , y (in log-diff form), obtained from the SSP2 scenario to yield trajectories of damaged GRPpc growth rates, ρ r , y . These trajectories are aggregated over time to estimate the future trajectory of GRPpc with future climate impacts:

in which GRPpc r , y =2020 is the initial log level of GRPpc. We begin damage estimates in 2020 to reflect the damages occurring since the end of the period for which we estimate the empirical models (1979–2019) and to match the timing of mitigation-cost estimates from most IAMs (see below).

For each emission scenario, this procedure is repeated 1,000 times while randomly sampling from the selection of climate models, the selection of empirical models with different numbers of lags (shown in Supplementary Figs. 1 – 3 and Supplementary Tables 2 – 4 ) and bootstrapped estimates of the regression parameters. The result is an ensemble of future GRPpc trajectories that reflect uncertainty from both physical climate change and the structural and sampling uncertainty of the empirical models.

Estimates of mitigation costs

We obtain IPCC estimates of the aggregate costs of emission mitigation from the AR6 Scenario Explorer and Database hosted by IIASA 23 . Specifically, we search the AR6 Scenarios Database World v1.1 for IAMs that provided estimates of global GDP and population under both a SSP2 baseline and a SSP2-RCP2.6 scenario to maintain consistency with the socio-economic and emission scenarios of the climate damage projections. We find five IAMs that provide data for these scenarios, namely, MESSAGE-GLOBIOM 1.0, REMIND-MAgPIE 1.5, AIM/GCE 2.0, GCAM 4.2 and WITCH-GLOBIOM 3.1. Of these five IAMs, we use the results only from the first three that passed the IPCC vetting procedure for reproducing historical emission and climate trajectories. We then estimate global mitigation costs as the percentage difference in global per capita GDP between the SSP2 baseline and the SSP2-RCP2.6 emission scenario. In the case of one of these IAMs, estimates of mitigation costs begin in 2020, whereas in the case of two others, mitigation costs begin in 2010. The mitigation cost estimates before 2020 in these two IAMs are mostly negligible, and our choice to begin comparison with damage estimates in 2020 is conservative with respect to the relative weight of climate damages compared with mitigation costs for these two IAMs.

Data availability

Data on economic production and ERA-5 climate data are publicly available at https://doi.org/10.5281/zenodo.4681306 (ref. 62 ) and https://www.ecmwf.int/en/forecasts/datasets/reanalysis-datasets/era5 , respectively. Data on mitigation costs are publicly available at https://data.ene.iiasa.ac.at/ar6/#/downloads . Processed climate and economic data, as well as all other necessary data for reproduction of the results, are available at the public repository https://doi.org/10.5281/zenodo.10562951  (ref. 63 ).

Code availability

All code necessary for reproduction of the results is available at the public repository https://doi.org/10.5281/zenodo.10562951  (ref. 63 ).

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Acknowledgements

We gratefully acknowledge financing from the Volkswagen Foundation and the Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH on behalf of the Government of the Federal Republic of Germany and Federal Ministry for Economic Cooperation and Development (BMZ).

Open access funding provided by Potsdam-Institut für Klimafolgenforschung (PIK) e.V.

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Maximilian Kotz, Anders Levermann & Leonie Wenz

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All authors contributed to the design of the analysis. M.K. conducted the analysis and produced the figures. All authors contributed to the interpretation and presentation of the results. M.K. and L.W. wrote the manuscript.

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Extended data figures and tables

Extended data fig. 1 constraining the persistence of historical climate impacts on economic growth rates..

The results of a panel-based fixed-effects distributed lag model for the effects of annual mean temperature ( a ), daily temperature variability ( b ), total annual precipitation ( c ), the number of wet days ( d ) and extreme daily precipitation ( e ) on sub-national economic growth rates. Point estimates show the effects of a 1 °C or one standard deviation increase (for temperature and precipitation variables, respectively) at the lower quartile, median and upper quartile of the relevant moderating variable (green, orange and purple, respectively) at different lagged periods after the initial shock (note that these are not cumulative effects). Climate variables are used in their first-differenced form (see main text for discussion) and the moderating climate variables are the annual mean temperature, seasonal temperature difference, total annual precipitation, number of wet days and annual mean temperature, respectively, in panels a – e (see Methods for further discussion). Error bars show the 95% confidence intervals having clustered standard errors by region. The within-region R 2 , Bayesian and Akaike information criteria for the model are shown at the top of the figure. This figure shows results with ten lags for each variable to demonstrate the observed levels of persistence, but our preferred specifications remove later lags based on the statistical significance of terms shown above and the information criteria shown in Extended Data Fig. 2 . The resulting models without later lags are shown in Supplementary Figs. 1 – 3 .

Extended Data Fig. 2 Incremental lag-selection procedure using information criteria and within-region R 2 .

Starting from a panel-based fixed-effects distributed lag model estimating the effects of climate on economic growth using the real historical data (as in equation ( 4 )) with ten lags for all climate variables (as shown in Extended Data Fig. 1 ), lags are incrementally removed for one climate variable at a time. The resulting Bayesian and Akaike information criteria are shown in a – e and f – j , respectively, and the within-region R 2 and number of observations in k – o and p – t , respectively. Different rows show the results when removing lags from different climate variables, ordered from top to bottom as annual mean temperature, daily temperature variability, total annual precipitation, the number of wet days and extreme annual precipitation. Information criteria show minima at approximately four lags for precipitation variables and ten to eight for temperature variables, indicating that including these numbers of lags does not lead to overfitting. See Supplementary Table 1 for an assessment using information criteria to determine whether including further climate variables causes overfitting.

Extended Data Fig. 3 Damages in our preferred specification that provides a robust lower bound on the persistence of climate impacts on economic growth versus damages in specifications of pure growth or pure level effects.

Estimates of future damages as shown in Fig. 1 but under the emission scenario RCP8.5 for three separate empirical specifications: in orange our preferred specification, which provides an empirical lower bound on the persistence of climate impacts on economic growth rates while avoiding assumptions of infinite persistence (see main text for further discussion); in purple a specification of ‘pure growth effects’ in which the first difference of climate variables is not taken and no lagged climate variables are included (the baseline specification of ref.  2 ); and in pink a specification of ‘pure level effects’ in which the first difference of climate variables is taken but no lagged terms are included.

Extended Data Fig. 4 Climate changes in different variables as a function of historical interannual variability.

Changes in each climate variable of interest from 1979–2019 to 2035–2065 under the high-emission scenario SSP5-RCP8.5, expressed as a percentage of the historical variability of each measure. Historical variability is estimated as the standard deviation of each detrended climate variable over the period 1979–2019 during which the empirical models were identified (detrending is appropriate because of the inclusion of region-specific linear time trends in the empirical models). See Supplementary Fig. 13 for changes expressed in standard units. Data on national administrative boundaries are obtained from the GADM database version 3.6 and are freely available for academic use ( https://gadm.org/ ).

Extended Data Fig. 5 Contribution of different climate variables to overall committed damages.

a , Climate damages in 2049 when using empirical models that account for all climate variables, changes in annual mean temperature only or changes in both annual mean temperature and one other climate variable (daily temperature variability, total annual precipitation, the number of wet days and extreme daily precipitation, respectively). b , The cumulative marginal effects of an increase in annual mean temperature of 1 °C, at different baseline temperatures, estimated from empirical models including all climate variables or annual mean temperature only. Estimates and uncertainty bars represent the median and 95% confidence intervals obtained from 1,000 block-bootstrap resamples from each of three different empirical models using eight, nine or ten lags of temperature terms.

Extended Data Fig. 6 The difference in committed damages between the upper and lower quartiles of countries when ranked by GDP and cumulative historical emissions.

Quartiles are defined using a population weighting, as are the average committed damages across each quartile group. The violin plots indicate the distribution of differences between quartiles across the two extreme emission scenarios (RCP2.6 and RCP8.5) and the uncertainty sampling procedure outlined in Methods , which accounts for uncertainty arising from the choice of lags in the empirical models, uncertainty in the empirical model parameter estimates, as well as the climate model projections. Bars indicate the median, as well as the 10th and 90th percentiles and upper and lower sixths of the distribution reflecting the very likely and likely ranges following the likelihood classification adopted by the IPCC.

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Kotz, M., Levermann, A. & Wenz, L. The economic commitment of climate change. Nature 628 , 551–557 (2024). https://doi.org/10.1038/s41586-024-07219-0

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Live Updates: Fed Holds Rates, Noting ‘Lack of Further Progress’ on Inflation

The Federal Reserve left interest rates unchanged and policymakers signaled concern about stubborn inflation. Jerome H. Powell, the Fed chair, said at a news conference that gaining greater confidence would “take longer than previously expected.”

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Jeanna Smialek

What to know about the Fed’s rate decision.

Federal Reserve officials left interest rates unchanged and signaled wariness about the recent pace of inflation, a hint that they may keep borrowing costs high for longer.

The Fed concluded its two-day policy meeting Wednesday, releasing a statement that included a few important changes from the last one in March. Central bankers reiterated that they need “greater confidence” that inflation is coming down before reducing interest rates from 5.33 percent, where officials have held them since July.

“In recent months, there has been a lack of further progress toward the committee’s 2 percent inflation objective,” the statement added.

Jerome H. Powell, the Fed chair, expanded on that at a news conference, explaining that “readings on inflation have come in above expectations,” and that gaining greater confidence that inflation was returning to target would likely “take longer than previously expected.”

The Fed is facing a complicated economic juncture. After months of rapid cooling, inflation has proved surprisingly sticky in early 2024. The Fed’s preferred inflation index has made little progress since December, and although it is down sharply from its 2022 highs, it remains well above the Fed’s 2 percent goal — calling into question how soon and how much officials will be able to lower interest rates.

Fed officials expected to make three interest rates cuts in 2024 as recently as March, but inflation’s recent stubbornness has made that look less likely. Many economists have begun to push back their expectations for when rate reductions will begin, and investors now expect only one or two this year. Odds that the Fed will not cut rates at all this year have increased notably.

Policymakers are mainly watching inflation as they try to decide what comes next with rates, though they are also likely to keep an eye on the momentum in broader economy.

Economists generally think that when the economy is hot — when companies are hiring a lot, consumers are spending and growth is rapid — prices will increase more quickly. Companies are more likely to raise wages as they compete for workers, and they will try to raise prices to cover their climbing labor costs. Consumers who are earning more are less likely to balk at heftier price tags.

But for months, Fed officials have been expressing comfort with the economy’s continued strength. Growth and hiring have not slowed down as much as one might have expected given today’s high interest rates, but policymakers were willing to embrace that resilience because inflation was falling anyway.

Now that inflation appears to be flatlining, though, officials may watch the economy’s vigor more warily.

A key measure of wages climbed more rapidly than expected this week, home prices rose more quickly than forecast, manufacturing looks strong , and economists are now closely watching a jobs report scheduled for release on Friday for any hint that hiring remains robust.

There are hints that the economy could cool. Overall economic growth slowed in the first quarter, though that pullback came from big shifts in business inventories and international trade, which often swing wildly from one quarter to the next. Small business confidence is low . Stock indexes fell in April. Job openings have come down substantially.

Economists also expect inflation to begin to come down again in the months to come, in particular as rent increases fade from key price measures.

Mr. Powell said Wednesday that he thinks policy is weighing on the economy, based on recent economic data, and said that he thinks another rate increase would be “unlikely.”

“I do think it’s clear that policy is restrictive,” he said. “We believe that over time it will be sufficiently restrictive.”

Fed officials also announced a plan on Wednesday to shrink their balance sheet of bond holdings more slowly. The Fed’s balance sheet exploded in size as the central bank snapped up securities during the pandemic, and officials have paring it down for months by allowing securities to mature without reinvesting the proceeds.

By making that process more gradual, officials hope that they will be able to reduce their footprint in financial markets without risking a market rupture. Officials had hinted that a balance sheet plan was coming.

Ben Casselman

One point Powell has clearly tried to emphasize in this press conference is that the Fed has made a lot of progress, even if that progress has slowed recently. Inflation has come way down, the job market has come into better balance, and overall demand has cooled.

Joe Rennison

Bond yields are falling and that is helping stocks rally. The two-year Treasury yield is now 0.1 percent lower for the day, on course for its biggest move lower in three months. The S&P 500 is over 1 percent higher.

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Lydia DePillis

Powell is asked whether this being an election year raises the bar for rate changes. “We’re always going to do what we think the right hing for the economy is. We’re not looking at anything else,” he said. “We’re at peace with that.”

Many Fed watchers have suggested that policymakers would be reluctant to cut rates right before the election lest they appear to be trying to help Biden. But, as he has before, he rejects that idea. “It’s hard enough to get the economics right,” he says, adding, “If you go down that road when do you stop?”

Jim Tankersley

The questions in this news conference have been split about evenly between whether rates should be higher or lower. But Powell keeps making clear that’s not where the Fed is: Officials are much more focused on the question of when to cut.

Powell pushes back forcefully against the idea that the economy is running the risk of “stagflation.” Inflation has fallen, growth is still strong and unemployment is low, he says. “I don’t see the stag or the flation,” he says.

Republicans have recently been raising the specter of “stagflation” in attacks on Biden; Powell is having none of that here.

The “stagflation” narrative frankly doesn’t make much sense. The risk right now is that the Fed is failing to cool off the economy, and that it will have to get more aggressive to tame inflation. That’s a real concern, but it’s nothing at all like the “stagflation” of the 1970s.

The Fed is keeping rates high, but is simultaneously slowing the roll-off of its bond holdings. On the surface, those two policies might seem to be at cross-purposes. But Powell pushes back against that idea, saying the bond policy isn’t an effort to stimulate the economy but just to avoid disrupting the financial system by reducing its holdings too quickly.

Powell is predicting that inflation is still poised to fall, but that he’s less confident in that than he used to be. “My expectation is that we will, over the course of this year, see inflation move back down” but “my confidence in that is lower than it was because of the data that we’ve seen,” he says.

Powell also makes clear, as he has in prior remarks, that the Fed doesn’t target a certain average wage level. Wages can rise faster than prices if production expands, which happened last year. Could that happen again this year? It would be harder, but it’s not impossible.

Powell dodges an effort to ping him down on when cuts might come, and whether it could happen this year. It will be up to the data, he says.

Some economists have suggested that all the talk of rate cuts basically worked against the Fed’s efforts to control inflation by leading to a rally in financial markets. But Powell pushes back against the notion that there has been a reacceleration in the economy. “What you see is economic activity at a level that’s roughly the same as last year,” he says.”

Investors are really welcoming Powell saying he thinks a rise in interest rates is unlikely, despite some other policymakers saying it could be possible. The S&P 500 is now up 0.9 percent.

The two-year Treasury yield, which is sensitive to changes in interest rate expectations, is also falling.

That was about as firm a “no” to Jeanna’s question as you’ll ever get from Powell. He doesn’t entirely rule out hikes, but he says explicitly they’re unlikely unless the data move in a substantial way.

In response to a question by our Jeanna Smialek, Powell said he thinks it’s "unlikely" that the next policy rate move will be a hike.

Howard Schneider at Reuters leads off the questioning by asking whether interested rates are “sufficiently restrictive.” That’s code for “Are you thinking about raising rates?”

Powell responds by saying he is confident interest rates are cooling down the economy and that he believes they will prove “sufficiently restrictive” over time.

Investors appear to be reacting positively to Powell’s initial comments, with a mini-rally starting after Powell said that interest rates are already “sufficiently restrictive” to slow the economy and inflation. The S&P 500 is now 0.5 percent higher for the day, having nudged lower prior to Powell’s answering reporter’s questions.

And that move is being exacerbated after Powell said that he thinks a rise in interest rates is “unlikely”.

Some economists have said recently that interest rates aren’t actually high enough to bring down inflation. Powell just disagreed with that assessment.

One of the most positive outlooks for employment is the Fed’s ability to use rate cuts as an insurance policy. “We are also prepared to respond to an unexpected weakening in the labor market,” Powell confirmed.

No surprise, but Republicans are blaming the lack of a rate cut on President Biden and his economic policies. “President Biden owns these historically high interest rates, making it harder for Americans to own anything else,” Representative Jason Smith of Missouri, the chairman of the Ways and Means Committee, said in a release.

That “longer than previously expected” line is not a surprise, but it’s the most explicit I’ve heard Powell be about the need for rates to stay “higher for longer.”

Powell notes that “readings on inflation have come in above expectations,” and gaining greater confidence will “take longer than previously expected.”

Jim Tankersley and Jeanna Smialek

Some Democrats are urging Biden to put pressure on the Fed.

Sky-high mortgage rates and other elevated borrowing costs are pinching American consumers ahead of the 2024 election, threatening President Biden’s chances at a second term .

Yet so far, Mr. Biden has not called on the Federal Reserve, which has raised interest rates to their highest levels in more than two decades, to slash those costs.

The White House has repeatedly cited the Fed’s independence as the reason that Mr. Biden will not push the Fed to cut interest rates. But some Democrats are now urging the president to jettison that approach. That is because the central bank, which was expected to cut rates early in 2024, is now unlikely to start reducing them anytime soon.