Accounting 101: Income Statement

by Joshua Botello

An income statement is the first financial statement that most business owners become accustomed to because it’s the easiest to interpret. Yet many of our clients just starting out are unsure how any of this financial stuff works. In this video, I’ll break down what an income statement is, its major components, and some useful formulas to better understand your business profitability.

What is an Income Statement

An income statement is a financial statement that shows how profitable a business is at a certain point in time. The income statement is also known as the profit and loss or P&L to show if they are making money by the job, month, or year.

The major components of the Income statement include sources of income, expenses, and a net income or net profit to show how profitable the business is. The income statement is helpful because it itemizes expenses incurred by operations. All of these costs have a definitive number and business owners can pinpoint where they can increase their margin and profitability.

Components

The major components of the income statement are naturally income in the form of sales revenue, operating expenses, and finally net income. Let’s take a look at each one.

Revenue

Sales revenue is the primary number in this section. This can be a single component listed as sales or broken down into product types or divisions depending on the level of detail you need.

This section can also account for Non-Operating Revenue, which could be interest or rent from a property that may not be the primary part of your business. This could include the gains from the one-time sales of property or equipment that can be accounted for here as well.

Cost of goods sold here and account for any labor or materials in direct relation to the manufacturing of a product or toward a particular service for a client. These are deductions from the Sales or Gross Revenue into Gross Profit.

Expenses

Expenses are broken down into a few different categories as you account for them on the statement. Primary activity expenses are your standard business utilities, rents, and costs of goods sold that are associated with making products or selling services. These expenses can also include wages to employees, commissions, and depreciation or amortization. There are secondary expenses that may include paying interest that is not related to core business activities. Losses are the final thing you may be able to account for such as a judgment in a lawsuit or loss-making sale of some equipment to name a few.

Net Income

Is the final calculation at the end of the income statement. This shows you the profitability of operations for a given point in time. What you need to understand about net income is that it’s not necessarily accurate. Some figures only exist in accounting and my not translate into tangible dollars like depreciation and amortization.

How to use one

Tracking your expenses and determining your net income isn’t the only thing an income statement is good for. There are a few more calculations you can use to measure your business’ profitability that I’ll cover right now.

Profit Margin

There are a few profit margin calculations you can use to measure your profit relative to your top-line sales revenue using this basic formula:

(Sales - Expenses) / Revenue X  100

If you want to compare revenue with your variable costs, or costs related to the production or selling instead of costs of goods sold, then you may want to Gross Profit Margin formula. This one is a little more involved:

Gross Profit = Revenue - (Direct Materials + Direct Labor + Overhead)

Net sales = Revenue - (Costs of sales returns, allowances and discounts)

Gross Profit Margin = (Gross Profit / Net Sales) X 100

Operating profit margin formula accounts for costs of goods sold, selling, and admin expenses and overhead

Cost of Goods Sold (COGS) = Beginning inventory + Purchases - Ending Inventory

Revenues + COGS - Selling and Administrative Expenses     x 100

Revenues     

Net Profit Margin is the percentage of the business revenue after deducting all expenses. 

Net Profit = Total Revenue - (COGS + Depreciation and Amoritization + Interest Expenses + Taxes + Other Expenses)

Net Profit Margin = Net Profit / Total Revenue x 100

All of these margin formulas are helpful but you need to be careful as they aren’t equal for all industries. Different businesses can operate on different margins and can still be profitable like restaurants, which do only about 3-5% margins. This means you should reference industry averages that match your business to see how your business is doing.

EBITDA

EBITDA, also known as earnings before interest, taxes, depreciation, and amortization is the measurement of a company’s overall profitability instead of net income. This is because all of these components are added back which could skew net income lower. EBITDA is used by bankers to determine the Debt Service Coverage Ratio for business loans or as a yardstick for corporate restructuring.
Conclusion

The income statement is valuable in providing insights into the efficiency in managing costs that could eat away at your profitability. While it does itemize many costs it may be difficult to without the use of ratios that we discussed earlier. As I mentioned before the income statement may not report true costs like depreciation or amortization that translate into real-world dollars. You should definitely work with an accounting program or CPA to set up your accounts to generate the document whenever you need it.

Funded in part through a Cooperative Agreement with the U.S. Small Business Administration. All opinions, conclusions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA.