How Do I Read An Income Statement and Why Is It Important?

Sep 28, 2020

This is Part 5 in our “All About Bookkeeping” series.

If you missed our first four articles check them out here:

What Is Bookkeeping and Why Do I Need Bookkeeping For My Business?

What Are Bookkeeping Debits, Credits, and Chart of Accounts?

What Is Cash and Accrual Accounting?

What Is An Income Statement vs Balance Sheet?

Now we get to start diving into the financial statements. First we are going to talk about the Income Statement or Profit and Loss.

1. What Is a Income Statement (also known as Profit and Loss) Recap?

Shows you how profitable your business is over a period of time.

  • Account Types: Revenue and Expenses
  • Time Frame: Any period you would like, however typically: monthly, quarterly, or annually.
  • What Does the Income Statement Tell You? How much money you made, how much money you spent, profitability of your business

2. What Are the Different Parts of An Income Statement?

Income, Cost of Goods Sold, Gross Profit, Operating Expenses, Opearting Income, Non-Operating Activity, and Net Income

SAMPLE INCOME STATEMENTIncome Statement - Demo Company

  • Income or Revenue: This area represents your earnings or sales of the business. You can have multiple line items so lets say you have a service but also sell some product, you could break those out but either way it would all be located in that income or revenue section. If you have refunds, returns or discounts, they can often times be found here too.
  • Cost of Goods Sold or Cost of Sales: Many call this COGS for short. This represents the price you pay to create your product or service. These are items that would be directly related to the revenue that comes in and NOT just normal operating costs. These are costs that are directly tied to the sales and would not occur if you did not have sales. Example: Lets say you are an electrician and purchase cable wire for a job you are working on, this would be a COGS item.
  • Gross Profit: This is simply a calculation of Income or Revenue less Cost of Goods Sold. Essentially it is your income for your business before factoring in the other opearting expenses.
  • Operating Expenses: These are all of the other indirect costs associated with running your business. Examples include Advertising, Automobile Expenses, Consulting & Accounting, Meals, Office Expenses, Rent, Repairs and Maintenance, Utilities, etc. You will have a good bulk of your expenses in this section. There are a few types of operating expenses:
    • Fixed Expenses: These are the same every month or period. Examples could be rent or certain software subscriptions.
    • Variable Expenses: These are items that can change from month to month. Examples could be advertising costs or meals.
  • Operating Income: This again is simply a calculation of Gross Profit less Operating Expenses. This is essentially the income (or loss) from your business before factoring in non-operating related items.
  • Non Operating Income or Expenses: This would include things that do not play into the normal day-to-day operations of the company. This could include interest income, interest expense, income tax expense, etc. If you have significant items in this area it is nice to separate these out so that can get more clarity from your financials.
  • Net Income (or Profit/Loss): This is the final stopping point that factors in everything we discussed to come to your “bottom line”, whether your business had a profit or a loss.
  • Simply Way To Think About Income Statement: You start at the top and it starts with a positive number, your sales/revenue. As you go down your Income Statement there were will various types of negative numbers or expenses that are cutting against your sales. Finally at the bottom you will see what your profit was after factoring in the income you received and expenses you paid.

3. Why Is An Income Statement Important? What Can I Do With the Information From a Profit and Loss?

It is important to not just complete bookkeeping and then move on, but to actually take the data that comes from the bookkeeping, including the income statement and utilize that to cut costs and grow your business!

  • Think Deeper Than Just Net Profit: So many business owners we talk to think only about profit. While this is an important number it is just as important to dig deeper than that.
    • Sales/Revenue: Look at this area, is this number dropping? Why is it dropping? Has it been increasing, how do we continue that? What can we do to increase this on an on-going basis?
    • Cost of Goods Sold: Are we paying too much for our product? If we buy in bulk can we get a deal?
    • Operating Expenses: Are we still utilizing these items? Are we paying too much for anything? Have we shopped insurance or cell carries? Are these expenses all necessary? How are we trending here?
    • Non-Operating Activity: Can we move our savings to a CD to gain more interest income? Can we refinance to lower interest?
  • Utilize Comparative Periods: It is best to compare periods to prior periods. This can help spot areas for savings or ideas for future growth. Put a marketing plan together in Q1, how did that change sales in Q2? How are your sales compared to last year?
  • Create Forecasts / Projections: Prior data is great to see performance in the past and see where cost cutting opportunities exist. However, you have to take actions on prior data because your business is moving forward. Using this data we have we can easily create future projections and forecasts or budgets. We can take a month by month income statement and have a general idea of trends that we can predict into the future. This can help you be better prepared and plan for things that matter in your business.
  • Plan / Consult / Execute: Simply put, USE THIS INFORMATION. Income statements and financials can be so valuable for the growth and future of your business but if you just let it sit on the table it doesn’t do much good. Use the information to plan for the future to plan on ways to cut costs or  increase revenue. If you are unsure in certain areas, consult someone to help you on this journey. Finally take what you’ve learned and execute. Too often business owners get wrapped up in the day-to-day and their business goes stagnant. Execute to grow your business and reach the goals you want.

4. Final Items Related to the Income Statement

Some additional things to consider.

  • Accrual vs Cash: Remember in a previous article we discussed cash vs accrual accounting. You can run an income statement using both methods. As a refresher, cash basis is you record income as it is received and expenses as they are paid. On an accrual basis you report income as it is earned and expenses in the period they are associated with (regardless of when money is received or spent).
  • Asset Purchases/Depreciation: Last week we discussed that major asset purchases go to the balance sheet and then they are depreciated which is when they come to the income statement. This is often something that happens during tax season. Make sure you understand this throughout the year. You may have bought a new business vehicle for $50k but depending on the depreciation method you may not expense that all in year 1, instead it may be depreciated across multiple years. It will not show up on the income statement until actually depreciated since the initial purchase is booked to the balance sheet.
  • Owner Draws/Distributions: If you are taking money from the business as an owner that is not processed through payroll, generally this would be considered an owners draw, distribution or dividend and this it NOT an expense to the business, instead it is also a balance sheet item.
  • Loans: The only loan related items on the income statement would be the interest portion. Incoming loans and outgoing loan payments are balance sheet items, not sales or expenses.

This article was meant to give you a deeper look into the income statement (profit and loss). Next week we are going to be diving into the balance sheet with coincides with the income statement in reporting.

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