An income statement is one of the three major financial statements every business needs to properly assess whether they are profitable and well on the way to reaching business goals. While the balance sheet tracks assets, liabilities, and capital and the cash flow statement tracks the amount of cash or cash equivalents that remain in the business, the income statement tracks income and expenses.
Also known as a profit and loss statement (P&L), the P&L, in its most basic form, reports the gross profit, expenses, and net profit for a specific period of time. While a small company with few bookkeeping requirements may only produce an annual P&L, most companies find it useful to create a monthly and possibly a quarterly statement.
Income statements serve many purposes aside from sampling reporting a profit or loss. When compared to other period, the income statement can help you identify where expenses of the cost of goods sold have significantly change. You can also compare the income statement to your budget to determine where you may need to reforecast future earnings. These comparisons can also help you spot errors in the company’s bookkeeping. For example, if utilities cost $1,000 in January, 2017 but in December, 2016 and January, 2016 utilities cost $500, then your bookkeeper may have recorded two months’ worth of utilities in January, 2017. Your bookkeeper may also have misclassified some other expense as utilities.
Parts of an Income Statement
Since the goal of financial statements is to provide useful information to the owner, you are not limited to creating an income statement in one specific format. While Company A may want to keep it as simple as possible, Company B may want the ability to see minute detail and compare revenues and expenses between months or years. In general, though, a P&L can be broken down into heading, sales, and expenses.
Because financial statements contain historic information that you may want to refer back to infrequently, it is important to add a heading. The heading usually has the company name on the first line. The second line identifies the document as an P&L, and the third line indicates the period of time covered; for example, "For the month ending January 31, 2017."
The first section of the income statement identifies the sales less the cost of goods sold to arrive at a gross profit. If the company specializes in more than one revenue stream, such as Cars, Houses, and Trains, the owners may elect to list each source of income and the related direct cost of goods sold separately and then summarize into gross profit. The cost of goods sold is made up only of those costs that can be directly attributed to the cost of producing the goods or services, such as materials and labor.
Typically, businessmen list the operating expenses related to the making a profit prior to listing the non-operating expenses. Operating expenses might include the cost of shipping products and sales costs, depreciation, amortization, building rent, staff salaries, research and development, advertising. Non-operating expenses may include the depreciation or amortization, interest charges, lawsuit settlements. All the expenses are totaled to arrive at the total expenses.
The total expenses are then subtracted from the gross profit to determine the net profit or loss. You can take it a step further and track the net profit or loss before and after taxes.
Profit or Loss
The main purpose of a P&L is to determine if the business is profitable, and if not, why not. It is also a vital tool in determining whether the books are error-free and profits have been maximized.
When analyzing the results, ask these questions:
- Why might sales be up or down this period? Did a new advertisement bring in new customers? Were customers lost to a new competitor down the street?
- Are costs of goods sold consistent with budget? If not, why? Did a vendor increase costs? Is overtime up? Why? What can be done to reduce costs while maintaining quality?
- Are operating expenses consistent with prior period? If not, why? Was an order for stationary or toner that would last the company several periods? Did you hire additional staff for a special project?
- Could you get more out of the statement if it were more detailed in certain areas?
- What products or services sell well and which ones are duds? Is there a way to make the duds into winners or should you consider changing the products or services you offer?
Variations of an Income Statement
Many people find it useful to create a comparison column on the income statement. In this column, you can track the budgeted amounts for the period, the amounts from the prior year for the same period, or the amounts from the prior month. An additional column may be used to record the amount of change between the budget or prior period and the current period in either dollars or as a percentage. You may want to establish a variance tolerance for further review. For example, if there is more than a five percent difference between budgeted and actual expenses, it may trigger further analysis. Be prepared to make revisions after visiting the triggered line items.
Many software packages will automate the P & L process. While this is an awesome, time saving tool, keep in mind that the end result is only as good as the information input into the system. As a business owner, it is still in your best interest to thoroughly review your financial statements on a regular basis.
While the primary purpose of all financial statements is to provide the owner with usable information in order to make the business more profitable, it is also meant to provide a uniform format for sharing the information with stakeholders. Frequent changes to your format may lead to errors and concerns that you may be trying to hide pertinent business trends. Consider carefully what information you want consolidated or elaborated upon within your P&L upfront and it will save you trouble down the road.