This is the second post in a series on understanding your financial statements. I have talked about the balance sheet. Today I will talk about the income statement and next I will talk about the statement of cash flows. Then I will end this series on how to analyze all three financial statements together to get an understanding and clear picture of your business finances.
The Income Statement is most referred to as the P&L statement or the profit and loss statement. Although that is an accurate description, the income statement is the “official” term. This financial statement is the most looked at of the three financial statements however when viewed by itself, the overall financial health of your business may not be accurately portrayed.
The Income Statement is the most viewed of the three financial statements and it shows the profitability of a business during a specific timeframe. It is sometimes referred to as the P&L statement or the profit and loss statement. This financial statement shows the revenue, expenses, gains and losses of the business, but doesn’t show the amount of cash coming in or going out. At the end of the statement, the net profit or loss is given thus telling a business owner whether they are profitable.
The basic equation for the income statement is as follows:
Revenue/Gains – Cost of Goods/Services Sold = Gross Profit
Gross Profit – Expenses/Losses = Net Income/Loss
Let’s look at the breakdown of the income statement within the basic equation.
Revenue/Gains
Revenue has many different names; income, earnings, profits or sales. Revenue occurs when money is earned, not when it is received with accrual-based accounting or when it is received with cash basis accounting. Gains are gains from the sale of a long-term asset when the gain is more than the book value of the asset.
Cost of Goods/Services Sold (COGS/COSS)
Cost of goods sold is the expense incurred for raw materials, direct labor, and overhead directly associated with the production of the good. It can also be the purchase of a wholesale item that a business resells. Cost of services sold are direct expenses incurred to render a service.
Gross Profit
Gross profit is calculated by subtracting cost of goods/services from the revenue.
Expenses/Losses
Expenses are incurred to earn normal operating revenues. Losses are incurred from activities such as the sale of long-term assets.
Net Income/Loss
The difference of gross profit and expenses equals the net income or net loss during that period.
Why is the Income Statement Important?
The income statement is important to understand if your business is profitable. Proper management of your income statement is key when sales/income increase because you want your expenses to grow at the same rate or slower than your increase in revenue. Managing expenses in relation to revenue is what helps in the success of a business. It can be used as a tool to help in decision making within your business.
Remember the income statements only reflects your profitability, not the cash flow of your business for that specific timeframe. It shows your revenues/gains minus cost of goods or services sold which equals gross profit. Your gross profit minus your expenses/losses equals your net income/loss. Keep in mind that when the income statement is viewed by itself, the overall financial health of your business may not be accurately portrayed.
If you found this helpful, like this post and share with a fellow business owner.