This post is instalment 2/3 of the essential financial statements series.
Income statements can provide incredibly useful insights into a company’s profitability over a certain period of time; however if the categories and the layout are unfamiliar then they can be overwhelming and seemingly uninterpretable.
To help you understand, I made an income statement for the fictional international law firm, George’s Law Updates LLP.
George’s Law Updates LLP Income Statement for 2025
| Revenue | £120,000,000 | Gained from management fees and successful exits |
| Cost of Goods Sold | (£30,000,000) | This section includes due diligence fees and transaction costs |
| Gross Profit | £90,000,000 | Strong margins |
| Operating Costs | (£40,000,000) | This includes salaries, the rent for the office and marketing |
| Operating Income | £50,000,000 | An operating margin of 42% |
| Interest Expense | (£5,000,000) | Debt financing for leveraged buyouts |
| Pre-tax Income | £45,000,000 | Shows disciplined leverage |
| Taxes | (£9,000,000) | Uk tax rate of 20% |
| Net income | £36,000,000 | Final profit (30% net margin) |
This particular example shows what each of the categories would entail for a large law firm; however the terms on the left can be seen across all income statements.
What all of the terms mean:
Revenue: The total income a business earns from its primary activities during a specific period, before deducting any costs or expenses.
Cost of Goods Sold: The total of all direct costs incurred in order to produce or deliver the foods or services that a company sells during a specific period. It is deducted from the revenue to calculate the gross profit.
Gross Profit: The amount of money a company earns after subtracting the cost of goods sold from its total revenue.
Operating Expenses: The ordinary and necessary costs that a business must incur to run its day to day operations. Typically includes rent, utilities, salaries, marketing, insurance and administrative costs.
Interest Expense: The cost a company pays for borrowing money, recorded as a non-operating expense and represents the interest payable on loans, bonds and other debt instruments.
Pre-tax Income: The profit a company makes after subtracting its operating expenses and interest costs, but before deducting its income taxes.
Taxes: The compulsory financial charges a business or individual owes to the government.
Net Income: The amount of money a company has left after subtracting all of its expenses including operating costs, interests, taxes and depreciation from its total revenue.
Income Statement Warning Signs
Lawyers and auditors can pick up on red flags within the income statement, some of the most common ones they see are:
- Revenue Concerns
If there are unusual spikes or dips in a company’s revenue as listed on the income statement, without clear business reasons, this can be suspicious.
If a company has overly consistent growth then it could be seen as too smooth and perfect to be authentic, which could be suggestive of financial manipulation.
If a company has a heavy reliance on one particular customer or product line, this makes them more prone to risk, as they lack diversification of operations and they are putting all their eggs in one basket so to speak.
2. Suspicious Expenses
If operating expenses are rising rapidly, this could be concerning for income statement readers, particularly if it is outpacing revenue growth.
If gross margins are declining and/or if the cost of goods sold is rising faster than the company’s revenue.
Excess costs, sometimes administrative costs, that are significantly higher than competitors in their market; suggest an inefficiency of operations and the presence of some hidden problems.
3. Profitability Issues
If a company’s operating income is shrinking despite them having a stable or growing revenue.
If their net income has been boosted by one off gains rather than their consistent operations, these can include litigation settlements or asset sales which can cause an abrupt spike in income.
If there is a pronounced gap between a company’s operating income and their net income, as this could indicate high interest costs or other underlying issues.
Key questions that lawyers and auditors ask when reading an income statement
Does the income statement fairly represent the business’s true performance?
Are the figures supported by invoices, contracts and other documentation?
Which systems are in place to prevent fictitious inflation in numbers of the company’s income statement.
How do current figures compare to previous years, and what is the causation of any variation?
“I call it the Rule of Three. If you read a company’s financial statements three times, and you still can’t figure out how they make their money, that’s usually for a reason.”
James Chanos, Founder of Kynikos Associates
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Written by George Hocking
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© George Hocking, 2025
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