While income statements don’t cover everything you need to know, you can utilize them alongside balance sheets and cash flow statements to create a fuller picture of your financial and business performance.
The ins and outs of income statements
In his book, How to Keep Score in Business, finance and accounting author Robert Follett observed that business owners are often confused when it comes to keeping track of their finances.
He argued that it’s easy to get mixed up with the smaller-picture data like profits, assets, and cash flow rather than take a step back and look at a company’s finances as a whole.
Whether you’re stepping into the accounting realm for the first time or have always crunched the numbers your accounting team puts together, there’s no doubt that the more minor aspects of your business’ financial health can be overwhelming to track.
And that’s why your core business activities need income statements: These handy financial documents are essential for business planning and ensuring your company’s financial health.
What is an income statement and why is it important?
Whether you generate one monthly, quarterly, or annually, an income statement (also called a profit and loss statement) should show you the revenue, expenses, profits, and losses your business experienced during that given period.
Overall, income statements are essential to understanding whether your company is performing well and gives you a glimpse of your company’s profitability.
While income statements can’t provide everything you need to know, they can do a lot. Here’s an overview of the pros and cons of income statements:
The most obvious benefit of income statements is that they provide insights into your company’s financial health. That’s why they’re an ideal document to present to investors, lenders, and creditors. Essentially, you’ll need them when you want to expand your business capital down the line.
Additionally, income statements are a useful tool when forecasting. Business forecasting is the process of making insights and predictions based on current and past information, which is helpful when you’re making big-picture decisions like creating budgets or setting future goals.
Income statements don’t cover the whole picture: They’re simply a surface-level explanation of your business’ financial data. So, looking at them alone, you could miss important information that might be reflected in other financial statements.
It’s also worth noting that income statements are time-consuming to create unless you have accounting software or an expense management system that can pull and automate the numbers for you.
The four essential aspects of an income statement
An income statement shows three parts: revenue, expenses, and profit. Some income statements also have a section for losses, which is essential for businesses with assets like stocks, bonds, and property.
The revenue section (sometimes referred to as “the top line”) reflects the money you generate from regular business operations and activities, like sales.
High revenue is necessary to pay your employees’ salaries or wages, rent, utility bills, equipment, and anything else your business requires for daily operations.
The expenses section refers to your business’ costs to continue operating and to generate revenue. It includes employee wages, utility payments, materials costs, rent or mortgage payments, debt or restructuring expenses, and office supplies and equipment.
The profit section (sometimes referred to as “the bottom line” or “net income” on the sheet) reveals how much your company makes in revenue against expenses. A positive number in this section means that you’re in good shape because your costs don’t exceed your income.
This section on an income statement is reserved for when you sell an asset and realize either a gain or a loss from the transaction. Usually, businesses with investments in stocks, bonds, and real estate will use this section of the income statement.
Viewing an income statement in action
To get a better idea of how an income statement works, let’s break down the basic calculations by looking at an income statement example.
When generating this statement, the first figure you want to find is gross profit. You’ll calculate the gross profit by subtracting net sales from the cost of goods sold.
Then you subtract your general expenses from your gross profit to find your operating income. And to find your income before income taxes, also known as your earnings before tax (EBT), you subtract interest expenses and any losses incurred from selling an asset.
And finally, to find your net income, subtract your income tax expense from your EBT. The result is your net income, also known as your bottom line income.
The line items on the income statement example above are pretty standard. Here’s an explanation of what each item represents.
Also called sales or net sales, revenue is the monetary value of sold goods and/or services provided to customers. It’s the money your business brings in each period. This figure helps determine the net income at the end of the statement after deducting expenses.
Cost of goods sold
The cost of goods sold (COGS) focuses on the expenses incurred to produce and maintain the goods and services provided to customers. For example, costs may include what you pay to ship raw materials to a factory, manufacture the product, and then package that product.
COGS can also include direct labor expenses. However, it doesn’t include salaries and wages for employees not involved in the production process, such as administrative or marketing staff—those labor costs are included in your general operational expenses.
Gross income creates a break in the statement and considers the business’ earnings after the COGS expenses are subtracted from the revenue.
This figure serves as a helpful window into a company’s financial performance because it shows how much you’re actually earning once you account for the costs of production.
Basically, you want to have a positive gross income to ensure that the cost of goods is not more than the actual income generated from selling those goods.
General expenses may include operational business costs like rent, salary, utilities, supplies, and non-operational costs such as marketing campaigns, debt payments, and equipment upgrades.
If you are currently borrowing money, you need to consider your interest expenses. Many larger companies have interest expenses for bonds, loans, credit, or debt financing.
Interest costs can eat up a significant chunk of your revenue when you’re dealing with large commercial loans and other business funding sources, so it’s essential to add this to your income statement to get a clear picture of your company’s financial performance.
Earnings before tax (EBT)
Serving as another break, your earnings before tax looks at the total revenues a business receives after incurring marketing, general, and interest expenses, but before taxes are considered. This section may also be called “operating income.”
Income tax is the amount of tax you owe based on your income thus far. The rate differs depending on where your business operates, so you’ll be looking at your state’s tax requirements and federal tax owed.
Lastly, your net earnings—also called net income or profits—reflect your final income after all expenses and taxes have been deducted. A reasonable profit margin sits between 15 and 20%, but the higher the number, the more profitable your business can be in the long run.
You can determine your net profit margin by dividing your net income (profits) by your net sales (revenue) and multiplying by 100.
How to work with a monthly, quarterly, or annual income statement template
Even if you have accounting software, you still need to know how to create an income statement. By doing so, you can familiarize yourself with the ins and outs of this essential financial statement—plus, you can quickly analyze the numbers when you know how to use them.
Step #1: Begin with a reporting period
Most accounting teams create an income statement monthly, quarterly, or annually. Annual income reports are always essential to compare your revenue and expenses year-to-year, but it’s recommended that you generate one more than once a year.
Creating one every month can give you a much more in-depth look at your business’ finances, which allows for more hands-on management and a better chance to spot trends, risks, and opportunities. However, this can be time-consuming for your accounting team.
For many companies, quarterly is a happy medium. But if you’re a publicly-traded company, you’re required to make an income statement every quarter because you need to send it to the U.S. Securities and Exchange Commission (SEC) every three months.
Step #2: Generate a trial balance report
You need to get your numbers from somewhere, and this is where a trial balance report comes in handy. This bookkeeping worksheet shows a simple bird’s-eye view of each ledger account. It includes your closing balances, which you can directly input into your income statement.
You can create one manually, but it will save you a lot of time if you use automated software that calculates your numbers for you instead.
Step #3: Calculate your total revenue
Remember that your total revenue is the amount of money your business made before any expenses or deductions. The formula for finding your total revenue is:
Step #4: Calculate the cost of goods/services
Your cost of goods is how much it costs to maintain a product or service. As stated before, this could be shipping and inventory costs. The formula for calculating your cost of goods is:
Step #5: Calculate gross profit
Your gross profit is how much revenue is left over after you’ve subtracted the cost to maintain your inventory or services, so the formula for calculating gross profit is:
Step #6: Calculate operating expenses
Make a list and add all of your everyday expenses, including salary, rent, utilities, supplies, and other essential costs that help with your business’ day-to-day operations.
Step #7: Calculate interest expense
If you have any outstanding loans, bonds, or other debts, consider the interest on all of these liabilities. Use this formula for each of your liabilities and then add the total interest expenses together:
Step #8: Calculate taxable income
If you’re eligible for any deductions (most businesses are), keep track of them and add them together. If you use a tax tool, you’ll list all of your deductions there and can simply draw upon this record for your income statement calculations.
Once you have the amount of your deduction, use this formula to determine your taxable income:
Step #9: Calculate net income
Finally, you’ll calculate your net income (or net profit) with this formula:
Analyzing your income statement
Although income statements show a lot of helpful information, the fact is that it can be hard to understand and digest all of the financial data at once—which is why many business owners and accountants take time to analyze them and assess how the numbers reflect actual performance.
There are two main financial analysis methods: vertical and horizontal analysis. Using both can help highlight some data that you might have overlooked and enable you to visualize the information in a way that’s much easier to understand.
Method #1: Vertical analysis
Vertical analysis aims to simplify your income statement. It can be hard to keep track of actual dollar and cents values, so vertical analysis makes it easier to understand the information by presenting each line item as a part of the total percentage of your company’s sales:
Take a look at the Year 1 example. You can see that the net sales always start with 100%, and as you know, your next step is to deduct COGS from the revenue, which in this case, accounts for 30% of the revenue, leaving a gross profit (also called gross income) of 70%.
Expenses are then deducted from the gross profit, which accounts for 38% of revenue, leaving the company with 32% for total net income. That means 68% of the revenue goes to expenses.
Method #2: Horizontal analysis
Horizontal analysis is an essential tool to compare a particular year’s revenue, expenses, and profits to previous years’. Comparing years across the board can help you see what differences and changes occurred.
Take a look at this example for Village Shipping Inc., which compares income statements between 2014 and 2015. On the far right, you can see a list of percentage changes from 2015 to 2014.
There are negative changes almost all the way down. This analysis ultimately tells the Village Shipping Inc. company that they did not make as many sales as the year before, and while total expenses dropped, also, the net effect was still negative.
You can see in the analysis that the culprits for these negative changes are fewer sales and several expense increases, such as repairs, rent, and office expense increases.
Keep track of all of your income statements in one place with the right tools
Income statements are among the three most essential financial statements that every business owner should know.
But it’s also vital that you track and keep your income statements organized, because having a proper record of past reports is:
- Essential to forecasting market trends
- Required by creditors, lenders, and investors
- Helpful when analyzing financial data, like revenue drops or expense increases
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