Together with the cash flow statement and balance sheet, the income statement is an essential financial report that your business should be using to monitor performance. As we round out our series on understanding your company’s financials, let’s dig into what an income statement is and why the insight it delivers is so important.
What is an income statement?
An income statement, also known as a P&L (profit and loss statement) or statement of operations, tallies and summarizes revenue earned and expenses incurred for a specific period of time. Unlike the balance sheet, which records business assets, liabilities, and equity, the income statement shows and tells a financial story about your business activities.
By deducting expenses (and losses) from revenue, your income statement reveals:
- How profitable you were during a particular reporting period
- How efficiently you’ve been managing your business
- How your financial performance stacks up against other companies or your competitors
If you run a corporation, your income statement will also include a calculation of Earnings per Share (EPS) – an important number for understanding how much money your stockholders would receive were your business to distribute its net income for the period.
Income statements are typically prepared monthly, quarterly, and/or annually.
Why it’s important to understand your income statement
There are 5 very good reasons why it’s important to understand your income statement as a business owner.
1. Gain visibility into profitability
Income statements let you compare your current financial performance with historical data to spot trends and understand how your business has grown. By outlining key, bottom-line numbers, your income statement gives you, your accountant, and any investors a complete picture of your operational results and how they translate into business efficiency, value, and a possible trajectory for the future.
2. Improve business performance
Because it also serves as a tool for comparing actual outcomes against planned results for a specific period, you can use your income statement to tweak your business activities, make better decisions, and improve your performance accordingly.
3. Track actual vs budgeted spend
You can even use your income statement to discover areas where you’ve over-budgeted or under-budgeted, and to drill down into specific activities that may be causing unexpected expenditures.
4. Meet lender or funder requirements
Whether you’re raising capital or looking for a business loan, your income statement – together with your balance sheet – is the document most lenders and investors will want to see.
5. Maintain financial compliance
No matter where you operate, your business is obliged to follow certain federal, provincial, and sometimes municipal tax regulations. As one of the 3 essential financial reports, your income statement provides a lot of the data required to stay compliant.
What is included in an income statement?
Generally speaking, an income statement is divided into 3 main sections: Revenue, Expenses and Net Income.
Here are some key components of those sections.
At the top of your income statement, the total revenue (or sales) amount reflects all the income earned from selling your goods and services during the period specified.
Cost of Goods Sold (COGS)
Sometimes called Cost of Sales (when the “goods” are specifically a service), COGS includes all the costs that were directly involved in producing and/or selling your product. Common examples include raw materials, parts, production labour, and depreciation of manufacturing equipment.
It’s worth noting that if you’re seeking ways to reduce business costs, COGS is the first place you should look.
Your gross profit line is equal to your revenue minus your COGS. Calculating your gross profit margin will show how efficiently your business turns direct costs into saleable goods. In most cases, the higher your margin, the greater your profits.
Operating expenses include those costs that are indirectly involved with running your business. Common examples include marketing expenses, rent, utilities, insurance, and other general or administrative expenses.
If you’re searching for more ways to reduce business costs, operating expenses are the second place you should look.
Depreciation & Amortization
If your business owns capital, long-term assets like large equipment or real estate, your income statement may include a depreciation & amortization (non-cash) expense line that spreads out asset costs over time.
As the name suggests, interest expense amounts reflect any business loan, credit card, or line of credit interest amounts you paid. You may also have a separate line for interest amounts your business earned from investments.
Once you’ve exhausted any cost reduction opportunities associated with COGS and operating expenses, your accountant may be able to help you lower interest expenses through debt prioritization, consolidation, or restructuring.
3. Net income
Also known as the bottom line, net income is the final amount showing on your income statement after gross profit, wages, taxes, and all other business expenses have been subtracted from your revenue.
Remember: the easiest way to prepare and then analyze an income statement is with the help of accounting software like QuickBooks Online (QBO) or Xero.
How to analyze your income statement
Analyzing your income statements won’t just allow you to monitor your business’s performance over time, it will help you measure your profitability against other companies’ gross, operating, and net profit margins.
There are 2 main ways to conduct an income statement analysis: horizontally and vertically.
1. In the horizontal method, you line up, review, and compare the same line-item amounts across multiple reporting periods. Analyzing annual income statements this way, for example, makes it easy to see year-over-year changes.
2. In the vertical method, individual line-items are shown as a percentage of total sales rather than as dollar figures. Analyzing these amounts as percentages lets you see the relative proportion of different business expenses.
Using a blend of both methods is the best way to gain a holistic view of your company’s revenue and expenses. But you won’t be able to achieve accurate, meaningful income statement figures unless you start with a proper set of books.
Need help getting your bookkeeping in order? Enkel can help! Contact us today and find out how easy we make it.