How do you know whether your company is profitable or losing money? Having a hunch isn’t good enough. You need to depend on facts, which you present in an income statement, also referred to as a profit and loss (P&L) statement. So what exactly does an income statement include, and how do you create one? It’s easier than you might think.
What’s an Income Statement?
An income statement, along with the balance sheet and cash flow statement, is one of the primary financial statements used to assess your company’s financial position. Also sometimes called a “statement of operations,” an income statement measures a company’s financial performance over a specific period of time. It’s typically generated monthly, quarterly, or annually, and it lists all relevant revenues, expenses, gains, and losses to calculate the company’s net income for the period.
Understanding your company’s profitability is vital to ensuring it delivers the necessary profits to stay solvent. Along with understanding your company’s profitability for a period of time, using your income statement to compare its profitability to a prior time period is equally important. This helps you gain a view of whether the company’s sales and profits have increased over time and can be an important tool to help you make informed business decisions. Income statements can also help demonstrate your company’s return on investment, risk, financial flexibility, and operating capabilities.
Choosing the time period for your statement depends on your needs. If you use the income statement to review your operations, select any period that works for you. This may be quarterly or even monthly. If you need the income statement for a loan application, typically the statement is year-to-date, ending with the most recent month. You may also need to provide a statement for the prior full year as well.
Determine Your Revenue
Revenue is all income your company receives, including:
- Operating revenue from the sale of goods and services.
- Non-operating revenue, such as interest received on loans made by the company or rent received from subleasing space.
- Gains on the sale of long-term assets (such as a vehicle, building, etc.) or other gains (like a lawsuit recovery). Gains reported on the income statement doesn’t represent the gross proceeds of a sale. It’s the amount by which the proceeds exceed the asset’s value on the company’s books.
You report revenue on an income statement when goods or services are provided to the customer. Practically speaking, if you perform a service, account for revenue when the work is done, even though you haven’t yet received payment. Similarly, if you’re a retailer selling goods, report the revenue on your income statement when the goods are sold, even though the invoice for the transaction isn’t yet paid. If you’re paid on the spot — either with cash, a cheque, or a credit or debit card payment — then receipts and revenue are the same for the purposes of your income statement.
Figuring Your Expenses
The next step to creating your income statement is to list and sum your incurred expenses. It’s beneficial to separate these expenses into categories to help you see how much you spend on each type of expense. Typical expenses include:
- Operating expenses, which covers the cost of goods sold if you have inventory, payroll, overhead (such as rent, utilities, insurance, and communication costs), and marketing.
- Non-operating expenses, such as interest expense, which accounts for interest payable on debt.
- Losses on the sale of assets and lawsuit damages. Losses reported on the income statement are the amount by which the proceeds are less than the asset’s value on the company’s books.
You usually report expenses when there’s a liability for payment. For example, employee compensation is an expense even if the company hasn’t yet paid it. It’s a good idea to match an expense to a stream of revenue for reporting purposes. In this vein, commissions owed to a salesperson make it onto your report when you report the revenue from the sale itself, even if the commissions haven’t yet been paid. Similarly, you report inventory expenses in tandem with sales of inventory items.
Not all payments by a company are treated as expenses on a P&L. As one example, paying down principal on a loan is an outlay of cash but not treated as an expense on the P&L. There may also be extraordinary expenses you want to display in a separate revenue category to highlight them and better understand your income and expenses for the period.
Creating an Income Statement
To create a manual income statement, it’s beneficial to start by selecting the method you want to use to list your entries. There are two basic methods:
Determine net income by subtracting expenses and losses from revenue and gains. Service businesses are the primary user of this type of statement. You simply list your revenue and gains, and add up your categories described earlier to find a subtotal of profit. List your expenses and losses according to the categories explained earlier, then add them up. The following equation shows this method:
- Net income (or loss) = (revenue + gains) – (expenses + losses)
Subtract your expenses and losses from the subtotal of revenue and gains. A positive difference is your net income. If the result is negative, this is your net loss.
The multiple-step method separates operating revenue and expenses from other revenue and expenses. This allows you to show gross profit, which is net sales minus the cost of goods sold. If you have an inventory-based businesses, you may find this method better suited for your needs. Again, you total your revenue and expenses in the various categories, factoring in the cost of goods sold to arrive at net income or net loss.
You can display the information in the way that’s most useful to you when using an income statement for internal purposes (not for bank loans or public consumption). If desired, you can segregate income and expenses according to product lines to see which line is more profitable.
When using an accounting system such as QuickBooks, you can generate an income statement automatically. You don’t have to enter revenue and gains or expenses and losses. Your system does this for you based on information you’ve already entered into your accounting system.
Understanding Your Income Statement
An income statement is a reflection of the company’s past activities and is a required statement for financial reporting (along with the balance sheet and cash flow statement). It’s important to track and review your income and expenses so you can plan for future growth. If you have concerns about creating or understanding your income statement, work with a CPA or other knowledgeable financial specialist.
As a small business owner, you need to run this report from time to time to get a measure of your financial health. Using an accounting system, such as QuickBooks Online, you can generate a Profit and Loss statement automatically. Learn how today.