Understanding your Income Statement (Part Two)
In the second installment of our financial statement series where we’re addressing the balance sheet, the income statement, and the cash flow statement and the inter-relationship between the three statements, we’re talking about income statements.
What is an income statement?
An income statement, alongside your balance sheet and cash flow statement, gives you a good idea and understanding of how your business is doing financially. Your income statement will show your company’s income and expenditures, whilst also showing whether you’re making a profit or a loss during any given period.
There are quite a few components to a typical income statement:
Revenue – This tends to be the first section you’ll see on an income statement, and it summarizes the gross sales made by your company.
Expenses – This section tells you about how much money your company has spent.
Costs of goods sold – The total cost of sales or services, which is also sometimes referred to as the cost incurred to manufacture your goods or services.
Gross profit – This is your total revenue after deducting the costs of goods sold.
Income before taxes – This is a measure of a company’s financial performance. Income before taxes is calculated by deducting your expenses from your income, before taxes.
Net income – This is calculated by subtracting your total expenses from your total revenue.
Depreciation – The extent to which any assets have lost their value over time.
However, we’re going to focus on the three main areas of the income statement: gross profit, expenses, and net income.
As we mentioned above, your gross profit on the income statement is the total revenue you’re left with after deducting the total costs of goods sold. This figure doesn’t include your other expenses. What your gross profit figure on your income statement can show you, however, is whether you’ve got the pricing structure right for your products or services.
If you’re finding that your gross profit is consistently low or a minus figure, then you may be offering your products or services at too low a price.
The expenses section shows you how much it’s costing to run your business, but doesn’t include the costs of goods sold. The expenses figure, or your operating costs, will include areas such as your employee salaries, any benefits they receive, the rent you pay for any office or warehouse space, utilities, etc. Some of these are fixed costs and won’t change on your income statement from month to month, like your employee salaries, but some may change over time.
If your expenses are outgrowing your gross profits, then it’s worth having a look at where you can potentially cut costs, especially around areas which may not be a core expense, or having a look at areas in the business where you can drive more sales.
And lastly we have your net income. This section of your income statement is an important one as it will tell you whether your company is making a profit or loss. Analyzing income statements over a longer period of time will give you a much better picture of which direction your company is headed in profit-wise.
If you find that you’re consistently making a profit, then that’s great! But if you find that you’re facing a trend of losses, then it might be worth looking at different sections of your income statement to see why it is you’re making a loss.
What’s the purpose of an income statement?
Your income statement is there to tell you about your company’s financial health and performance over any given period. This statement, alongside other documents such as your balance sheet and cash flow statement, will allow you to determine whether your company is making a profit or a loss, where your highest costs are, and whether you have enough spare money to start investing into savings.
You’ll find that it’s not only you as a business owner who reviews your income statements but also your accountants and, more importantly, your investors. They will also want to see how well the business is doing, if it’s reaching its goals, and if not, whether any action needs to be taken in order for the business to reach its expected goals. For example, a potential investor may choose to buy into your company if they can see that you’re exceeding your expected goals.
The importance of the income statement
Simple Startup loves helping entrepreneurs manage their accounting so they can make smart and informed business decisions. If you need help with the foundation of accounting in your business, we can help. We look at metrics as part of our bookkeeping, accounting and fractional support services and customize them specifically for each business we partner with. If you’re struggling with knowing your numbers or are not looking into your metrics yet, then grab some time on our calendar and see how we can support you and your finances.