How to Read Your Income Statement – Part 1

Income statement letter on brown envelope and eyeglass, business concept; document is mock-up

We’ve covered how to read your balance sheet here.  Another important financial report is the income statement – also called the profit and loss (P&L) report, statement of earnings, operations statement, or revenue statement.

Previously we told you that the balance sheet gives financial information on your business as of a specific day in time.  The income statement tells you how your business did financially over a period of time.   Typically you have an income statement for each month and a statement that shows your activity year-to-date.  Like the balance sheet, it’s helpful to compare current month or year to prior months or years to identify trends. 

What’s included on an income statement?

At the very basic level, the income statement answers several questions – how much did you sell, what did it cost you to make what you sold, and how much did it cost to run your business?  If you sold your product or service for more than it cost you, you have a profit.  If not, you have a loss.

We start with sales.

Sales/revenue is categorized as operating income.  It is the income from the sale of your business’s product or service, the reason you operate your business in the first place.  So it makes senses that the Sales/revenue is the very first line on the income statement. 

Much can be learned from this simple number  Are your sales growing?  Did they meet your projections?  How are they trending?  If you watch Shark Tank, you may have noticed that the first question the sharks ask after a business owner describes their product or service is what are their sales numbers.  This is the first line to look at for the health of your business. 

We subtract the cost of sales.

Cost of sales starts with how much money you spend directly making your products or delivering your service. 

What’s included in cost of sales is industry-specific.  If you are a retailer, your cost of sales is the merchandise that you purchase for resale.  If you are in a service industry, it is the cost of providing services such as direct labor.  The most complex is if you are a manufacturer.  For a manufacturer cost of sales includes raw materials, labor, and overhead.  It’s similar for construction companies – costs include materials, crew labor, equipment rentals, permits, and any subcontractor costs. 

Now we can calculate gross profit.

Subtracting cost of sales from sales revenue gives you your gross profit (or loss).  This is the income that will be used to pay other expenses incurred in running your business.   If you’re experiencing a loss, this could indicate that your costs need to be evaluated for areas of savings, or you’re pricing your product too low. 

Don’t forget selling, general and administrative expenses (SG&A).

There are other expenses associated with the running of your business.  They include items such as rent, insurance, utilities, and advertising.  These are costs that are not directly tied to your production of your product or service. 

Subtracting SG&A expenses from gross profit gives you your operating income.  Again, if this number is negative, then you will need to look at ways to operate more efficiently, or price better. 

Finally, we get to net income.

And then there are taxes. 

Who pays income taxes all depends on how you’ve structured your business.  For sole proprietorships, partnerships, LLC or S corporations, income is taxed once on the owner(s)’ personal tax return.  For C corporations the business itself pays taxes on its own tax return, and shareholders also pay taxes on any dividends paid out to them.  For a business, income after income taxes is called net income. 

Part 2

In the next installment, we will talk about key ratios that can be used to evaluate the health of your business.  So stay tuned….

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