Below gross profit: the operating expenses
In the previous guide you stopped at gross profit — revenue minus the cost of goods sold — the margin left after paying for the *thing you sold*. But a bakery does not run on flour alone. The shop needs a salesperson at the counter, a manager keeping the books, rent on the storefront, electricity for the lights, and an advertisement in the local paper. None of those costs are baked into a single loaf, yet without them there is no business at all. These are the [[operating-expenses|operating expenses]], and they live on the income statement directly below gross profit.
Accountants usually sort operating expenses into two buckets. Selling expenses are the costs of getting the product out the door and into customers' hands: advertising, sales commissions, the salaries of shop staff, delivery costs. General and administrative expenses — often shortened to G&A — are the costs of simply being an organization: office rent, the accountant's salary, insurance, software subscriptions. Together they are frequently labelled SG&A, for selling, general and administrative expenses, a line you will meet on almost every real income statement.
Operating income: how the core business actually did
Subtract all the operating expenses from gross profit and you reach a number with real meaning: [[operating-income|operating income]], sometimes called operating profit. This is what the company earned from *doing the thing it exists to do* — baking and selling bread — before any of the financial side-effects of how it is funded or how it is taxed enter the picture. If a firm earns healthy operating income, its core business model works. If operating income is negative while the bottom line still looks fine, something other than the actual business is propping up the result, and that is worth a hard look.
This is precisely why analysts love operating income: it lets you compare two companies' *businesses* fairly, even when their finances differ wildly. Imagine two identical bakeries earning the same operating income. One owns its building outright; the other borrowed heavily to buy its building and pays large interest every month. Below operating income their statements will diverge sharply — but at the operating-income line they look like twins, because that line deliberately stops before the financing story begins. The structure that lays these layers out one beneath the other is the multi-step income statement you met earlier in this rung.
Stepping outside the core: non-operating items and EBIT
Below operating income sit the things that happen *to* a business but are not the business itself — the [[non-operating-items|non-operating items]]. A bakery's whole purpose is bread, not finance; so when it earns a little interest on cash parked in the bank, or a dividend on some shares it happens to hold, that income is real but peripheral. The opposite side is interest expense: the cost of borrowed money. The bakery that took out a loan to buy its building owes interest every month, and that interest is a non-operating cost, because it flows from a *financing* choice rather than from the act of baking and selling.
Add operating income to the non-operating income and subtract the non-operating expenses *except* interest, and you arrive at a famous milestone: [[ebit|earnings before interest and taxes]], almost always written as its acronym, EBIT. As the name says outright, it is the profit a company has earned before its lenders take their cut (interest) and before the government takes its cut (income tax). EBIT answers a deliberately narrowed question: ignoring how the firm is financed and how it is taxed, how much did it earn? For two companies with very different debt loads, EBIT puts them back on the same footing.
Interest, taxes, and the bottom line
From EBIT, the last two subtractions finally take place. First comes interest expense — the lenders are paid before the owners. Whatever is left after interest is the profit on which the company is actually taxed. Then comes [[income-tax|income tax expense]]: the government's share of the year's earnings. Subtract both, in that order, and you finally reach the number the whole statement has been building toward — [[net-income|net income]], the famous "bottom line." It is the profit that belongs to the owners after every other claimant has been satisfied: suppliers, employees, lenders, and the tax authority, all paid first.
Revenue 500,000 - Cost of goods sold - 300,000 --------------------------------------------- = Gross profit 200,000 - Operating expenses (SG&A) - 120,000 --------------------------------------------- = Operating income 80,000 + Interest & investment income + 5,000 --------------------------------------------- = EBIT 85,000 - Interest expense - 15,000 --------------------------------------------- = Pre-tax income 70,000 - Income tax expense (~30%) - 21,000 --------------------------------------------- = Net income 49,000
Read the little ladder above as a story rather than a sum. Five hundred thousand of sales walked in the door; the ingredients cost three hundred; running the shop cost a hundred and twenty; the core business therefore earned eighty. A little interest income lifted it, a chunk of loan interest pulled it back down, and the tax authority took its slice — leaving forty-nine thousand for the owners. Notice that the same operating income of 80,000 could become almost any net income, depending entirely on how heavily the firm borrowed and how it is taxed. That is the whole reason the statement is built in layers.
What net income really is — and is not
It is tempting to treat net income as a pile of cash the owners can now spend, but that is the single most expensive misconception in all of accounting. Net income is *profit*, not cash. It was built using the accrual idea you met earlier on the ladder: revenue is counted when it is earned and expenses when they are incurred, regardless of when money actually moves. A firm can report glowing net income while its bank account drains — it sold a great deal on credit and has not been paid yet — or report a loss while cash piles up. Profit answers "did we earn?"; cash answers "can we pay?", and those are genuinely two different questions.
There is a second honest caveat. The income tax expense printed on the income statement is *not* the same as the cheque the company writes to the tax office. Accountants compute taxable income under the tax code's own rules, which differ from the rules used for the financial statements — a gap the field calls the difference between book income and taxable income. So "income tax expense" is an accounting estimate of the period's tax cost, not a record of cash sent. A whole later rung of this ladder is devoted to untangling that knot; for now it is enough to know the two numbers are cousins, not twins.
Net income is also where the income statement hands off to the rest of the picture. That bottom line does not vanish at year-end; it walks across to the statement of retained earnings you will meet shortly, where it raises the owners' accumulated stake before any dividends are paid out. For listed companies, net income is also sliced by the number of shares to give earnings per share, the figure headlines fixate on. But every one of those downstream numbers rests on the same patient descent you just walked — gross profit, operating income, EBIT, then net income — each layer a different, honest answer to the question "did the business make money, and for whom?"