How to Read an Income Statement
If you’re just starting a business, standard financial reports, like Income Statements, Balance Sheets, and Cash Flow Statements can seem daunting. But once you’ve mastered the terms and the math it’s easy to see how these statements dovetail neatly to track your company’s fiscal health.
Let’s start with the Income Statement, more commonly known as a Profit & Loss Statement (or P&L), which provides a high-level view of your company’s ability to make money. We've provided a sample P&L [PDF format] for you to use as part of this post. Either print it out or open it in a new window to follow along as we run through the basics.
The Math: Income – Expenses = Profit (or Loss)
What it tells you:
- How much money came into your company during a specific period
- How much money the company spent to generate that income
- How much profit (or loss) the company has after it pays its expenses
We’ll walk through the line items top to bottom, and translate the terms as we go. The most recent entries are always to the left of the prior-period entries, which enable you to compare year-over-year numbers, looking for trends at a glance.
Revenue - Income statements begin by listing the company’s income from the sale of products or services for a specific time period, usually annually, but it could be quarterly or monthly if you are just starting out. This amount may also be called “Sales” or "Gross Sales."
Less: Returns and Allowances - If you sell goods, this line item reports total returned and discounted merchandise, which is subtracted from gross sales.
Less: Cost of Goods Sold - The amount spent to buy or make the goods sold, such as the cost of raw materials and labor in manufacturing products that you sell. It’s figured using this formula: Beginning Inventory + Products Purchased – Ending Inventory = COGS. Service businesses will not have this line item.
Equals: Gross Profit – What’s left after deducting the direct costs of buying or producing your goods and services. Also called "Margin."
The next section on the P&L lists expenses for the same accounting period, which will be subtracted from Gross Profit.
Less: General and Administrative Expenses – Costs related to operating your business, such as rent, utilities, telephone, employee salaries, repairs and maintenance, insurance, and leasing equipment. Research and development costs may be included here, or reported as a separate line item.
Less: Sales and Marketing Expenses - Amounts spent to market and sell your products and services, such as advertising, trade shows and sales commissions. These two categories are sometimes combined and reported as Selling, General and Administrative Expenses (or SG&A).
Less: Depreciation and Amortization - The amount of the cost of assets like computers, copy machines and furnishings for general wear and tear that is written off over a period of time, commonly three to five years. Proper accounting rules require companies to spread the cost of depreciable assets over their expected useful life.
Intangible assets, which have no physical properties, such as patents, copyrights, trademarks, should also be expensed (or “amortized”) over a period of years.
Equals: Operating Income - The amount left after all expenses have been deducted from Gross Sales. This income, generated by the day-to-day operation of your business, is a key indicator of your company’s financial health. Comparing operating income year-over-year, or quarter-over-quarter, tells how much you are spending to earn a profit. Also called "Operating Earnings."
The next set of line items identifies miscellaneous sources of income and expenses that are not directly associated with running your business.
Nonoperating Income – Income not related to the day-to-day operations of the company, such as, interest earned on investments, or the gain on a sale of an asset.
Less: Nonoperating Expenses – Expenses not related to the day-to-day costs of running the business, such as interest on money borrowed, legal fees or restructuring costs after a layoff. The net result is your income before taxes have been deducted.
Less: Income Tax - Taxes on income after any investment tax credits have been subtracted is reported as a single line item expense.
Equals: Total Net Income - The company’s bottom line, or profit after all the above expenses have been deducted. If the number is negative (shown in parentheses) the company experienced a loss for that reporting period. Also called "Net Earnings."
Mastering this basic blueprint will give you a picture of your profitability in any given period. And it doesn't hurt to have generally accepted financial statements up-to-date when banks, accounting professionals and potential investors are evaluating your company.