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The financial statements are the most important part of any business, but they can be confusing and difficult to understand. There are a lot of different parts in an income statement that confuse even experienced professionals. Most small business owners don’t know what to look for when it comes to the income statement.
You need to know how your company’s finances really work so you don’t become one of those companies that ends up going bankrupt due to lack of understanding with what they're doing financially.
This article outlines the essentials for understanding income statements. If you're a small business owner who's looking to understand your company's financials more clearly this is an essential read!
What are small business financials?
First of all, small business financials are typically monthly or quarterly reports that provide a snapshot of your company's performance. These reports can be used to evaluate the efficiency and effectiveness with which you're managing your business and they can also help you make decisions about your company's finances.
What is an income statement?
One of those small business financial reports is an income statement. An income statement is one of the most important financial statements for a business. It tells you how much revenue your business has generated, how much money it has spent, and what the net profit or loss is for a given period of time. The income statement can be used to help make important business decisions, such as whether to invest in new products or expand into new markets or where to reduce expenses. An income statement is also known as a profit and loss statement.
What are the components of an income statement?
Revenue
Revenue is the top line or the first line item on an income statement. It represents the total sales or service income of a company before any expenses are deducted. This figure is also referred to as "sales" or "income".
Cost of Goods Sold
The cost of goods sold, also known as the cost of sales, is the direct costs incurred in the production of the goods or services sold by a company. This includes the cost of the materials used, the labor costs, and the manufacturing overhead costs. The cost of goods sold is deducted from the revenue to calculate the gross profit. An example of cost of goods sold would be the cost of "shoes" (inventory). When you purchase the shoes, the amount you paid would be tracked in inventory. Only when you sell the shoes would you remove the cost from inventory and expense it on your income statement under cost of goods sold. By doing this, you can start to see the margins on your sales.
Gross Profit
Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of providing its services. It's calculated by subtracting the cost of goods sold from revenue. This is the money your business has to work with to cover operating expenses (rent, payroll, insurance, etc.)
Expenses
There are three main categories of expenses on an income statement:
1. Cost of goods sold (COGS): This includes the direct costs associated with producing the goods or services that your company sells. For example, if you manufacture products, COGS would include the cost of raw materials, labor, and overhead. This has already been recorded on the income statement just below revenue.
2. Operating expenses: These are the costs associated with running your business, such as rent, utilities, advertising, and payroll.
3. Depreciation and amortization: This is the non-cash expense associated with the wear and tear of your company's assets, such as buildings, equipment, and vehicles. This does not affect the cash in your bank account but does incrementally expense the cost of assets to reflect their true value over time. If you buy an icecream food truck for your business, it retains it's value over a period of time (let's say five years). You would expense the food truck over the five years. However, if you buy an iphone, it loses it's monetary value in about a year when the next iphone comes out so it's expensed immediately. **I'm a bit bias**
Net Income or Loss
Net income or loss is the bottom line of an income statement. It is calculated by subtracting total expenses from total revenues. If the result is positive, the company has made a profit. If the result is negative, the company has suffered a loss. A loss for a few months may not always be a bad thing as long as the other months in the year can carry those losses. Cyclical or seasonal businesses tend to have some months of great profit and some months of loss.
How is an income statement used to understand small business financials?
An income statement is one of the most important financial statements for a small business owner. It shows your business' revenues and expenses over a period of time, which can be used to assess your business' overall financial health. The income statement can also be used to calculate important financial ratios, such as your profit margin. It also helps to see if the business is experiencing growth, stagnating, or experiencing a downturn.
What are some tips for reading and understanding an income statement?
Understand the difference between gross profit and net profit
There are two main types of profit that you will see on an income statement: gross profit and net profit. Gross profit is the profit that a company makes after subtracting the cost of goods sold from revenue. Net profit is the profit that a company makes after subtracting all of its expenses from revenue.
Gross profit is important because it shows how much money a company is making from its core business activities. Net profit is important because it shows how much money a company is making after all of its expenses are taken into account.
Insist on consistent bookkeeping
When it comes to reading and understanding an income statement, one of the most important things you can do is to insist on consistent bookkeeping. This means that all of the transactions that are recorded in the books of the company should be consistent with one another. If there are any discrepancies, it can be very difficult to figure out what is going on. For example, the monthly telephone bill should be recorded in the "telephone expense account" every month in order to compare the months.
Pay attention to the footnotes
When your accountant provides you with the final income statement for the fiscal year, pay attention to the footnotes. These can provide a lot of information about the items on the income statement. For example, they might explain why certain items are excluded from the total revenue figure.
Ask your bookkeeper or accountant questions
Don't be afraid to ask questions if you don't understand something. The goal is to understand the income statement so that you can make informed decisions about the company's financial health. Remember, this is your business. You pour your heart and soul into your business so ask questions and understand your small business' financials.
Compare expenditures and the bottom line
There are a few key things to look for when reading an income statement. First, compare expenditures to the bottom line. This will give you an idea of how much the company is spending on operating costs. Second, look at the net income. This will show you how much profit the company is making.
How can an income statement be used to improve small business financials?
An income statement can be used to track revenue and expenses.
An income statement can be a helpful tool for small business owners to track revenue and expenses. By monitoring income and expenses, owners can make informed decisions and make changes to improve financials. Additionally, an income statement can help owners identify trends over time and spot potential problems early on.
An income statement can be used to compare financial performance over time.
An income statement can be used to compare financial performance over time. This can help small business owners identify trends and make informed decisions about where to allocate resources. The income statement can also be used to assess the financial health of the business and to benchmark against similar businesses. It can be eye opening to look at the income statement over a period of months and compare each month either with the preceding or following month. Another way to look at the income statement is by comparing the current month with the same month in the prior year.
An income statement can be used for planning and budgeting for the future.
An income statement can be used for planning and budgeting for the future. By looking at the revenue and expenses for the past year, you can get an idea of where the business is currently at and where it might be headed. This information can be used to make informed decisions about what changes need to be made in order to improve the business' financial situation. If you are new to budgeting, a great starting point would be to use the past year's income statement with a few small tweaks, and voila, you have a beginner budget. Now you have numbers to benchmark against and you can always update your budget as your business pivots.
How can an Income Statement be used in conjunction with other financial statements?
How an Income Statement is Used with a Balance Sheet
Balance sheets are one of the most important business financial statements. They are often used in conjunction with income statements and cash flow statements to get a better understanding of the financial health of a company.
The income statement shows a company's revenue, expenses, and profit over a period of time. The balance sheet, on the other hand, shows a company's assets, liabilities, and equity at a specific point in time.
Together, these two financial statements can give you a pretty good picture of a company's financial situation. For example, if you see that a company's expenses are increasing but its revenue is staying the same, that's a red flag that something might be wrong. Alternatively, if you see that a company's assets are increasing but its liabilities are staying the same, that's a good sign that the company is in good financial health.
How an Income Statement is Used with a Cash Flow Statement
Cash flow statements are one of the most important financial statements for any business. They are often used in conjunction with income statements and balance sheets to get a complete picture of the financial health of a company.
The income statement shows a company's revenue and expenses over a period of time, while the cash flow statement shows how much cash is coming in and going out of the business.
For example, if a company's income statement shows that it is making a profit, but its cash flow statement shows that it is losing cash, this could be a sign that the company is not generating enough cash from its operations to cover its asset purchases or loan obligations. This could be a warning sign that the company is in financial trouble and may not be able to continue operating for much longer.
Conclusion
Now that you understand the income statement (aka Profit and Loss), dive in and look at your numbers. If you are using QuickBooks Online, you can do this easily by going to Reports > Profit and Loss > and play around with the period (dates) and display columns (I like months). Business financial management comes into play by analyzing these reports regularly and determining what you can do to help the business succeed financially. If you're not a fan of managing your small business finances, reach out to ThinkEasy and we'll prepare the financial documents for your business.