When you think about your business performance, you might first consider your income statement. It’s your picture of business health, documenting your revenue, profit, expenses, and more. To use your income statement effectively, you have to know what it is and how different statements interpret your business performance.
What is an income statement?
The income statement reports a business’s revenue, expenses, and profit for a period of time. In fact, financial accounting rules require every statement to include revenue, expenses, and net income. You may also refer to this report as the profit and loss statement or the statement of earnings.
The purpose of the income statement is to report profitability. You can improve your business’s bottom line by reviewing each line item in the report. As a small business owner, you should focus on the profit and loss statement if operating profit is your biggest financial performance concern. Income statements come in several formats that can help you perform a financial analysis.
What’s on an income statement?
The income statement formula subtracts total revenue from total expenses to calculate net income. The formula follows:
Total revenue – total expenses = net income
Revenue includes sales revenue and other transactions that generate a net profit. If you sell an asset for a gain, the gain is considered revenue. Often, company revenues are the “top line” in the report. You incur operating expenses to generate revenue. The difference between revenue and expenses is net income or earnings. Typically, business owners generate income statements monthly and annually.
There are three common types of income statements: multi-step, single-step, and common-size. Each presents revenue and expenses differently. Understanding each type of income statement can help you measure business performance.
What is a multi-step income statement?
The multi-step report formula subtracts sales, the cost of sales, operating expenses, and non-operating expenses to calculate profit. The formula follows:
Sales – cost of sales – operating expenses – non-operating expenses = profit
Every set of company financial statements should include a multi-step statement. The report provides more detail for making business decisions. Let’s look at an example. Oakwood Furniture is a manufacturing company. We can see their multi-step income statement for 2019.
|Cost of goods sold||(1,200,000)|
|Equals: gross profit||800,000|
|Salary and benefits||(240,000)|
Following Oakwood’s multi-step income statement, we can see their revenue includes sales and other transactions that generate cash inflows. These inflows include a gain on the sale of an asset. The cost of sales includes raw materials and labor costs directly related to products or services sold. Subtract total sales from the cost of goods sold (COGS) to calculate gross profit.
Operating profit explains a company’s ability to generate a profit from normal business activities. Operating expenses include costs indirectly related to the product, including insurance expenses and rent or mortgage costs. These costs are also defined as selling, general, and administrative (SG&A) expenses.
Finally, interest payments and income tax expenses are non-operating expenses. Net profit includes all income and expenses, including taxes. You can take data from a multi-step income statement to generate financial ratios.
What is a single-step income statement?
A single-step statement does not separate expenses into categories. A single-step income statement groups all expenses in one list. This type of statement is less beneficial than the others because it provides less detail on business operations.
|Gain on sale of equipment||4,000|
|Cost of goods sold||(1,200,000)|
For example, the single-step statement does not list gross profit, which is a valuable tool for managing a manufacturing company. Managers evaluate how well they’re controlling material and labor costs by analyzing gross profit. If gross profit increases, the business is increasing sales or reducing the cost of goods sold (a manufacturer’s largest expense).
The single-step model does not separate operating income and expenses from non-operating balances. The $4,000 gain on sale is a one-time event that isn’t identified as relating to continuing operations—in this case, making furniture.
What is a common-size income statement?
The common-size income statement allows you to compare financial performance between time periods using reports with different dollar amounts. A common-size statement presents each line item as a percentage of revenue or sales. Let’s look at Oakwood’s report, which uses sales to calculate the percentages.
|Less: cost of goods sold||60%|
|Equals: gross profit||40%|
|Salary and benefits||12%|
The percentage format makes it easy for Oakwood to compare performance between periods with different revenue and expense levels. Assume that the 2018 gross profit percentage was 35%. In 2019, Oakwood generated a higher gross profit (40% versus 35%) on each dollar of sales.
Using percentages, you can also compare performance to competitors or industry benchmarks. If Oakwood’s industry average for gross profit is 32%, they’re outperforming the industry. Company annual reports include a common-size statement to identify and compare trends.
Download free income statement templates
Download a sample income statement of each type to use them for your business. Then review how each statement presents the same data. You should generate the income statement before the balance sheet and cash flow statement.
How to prepare an income statement
1. Generate your month-end trial balance
The trial balance is a list of each account and the current balance. After you post all of the accounting transactions, generate a month-end trial balance.
2. Adjust the balance
Review the balances in the trial balance and make any needed adjustments or corrections. If your month-end bank statement reports $50 in interest earned, post an adjustment to recognize the interest income.
3. Create the report
Use the revenue and expense accounts in the adjusted trial balance to create the income statement. You may repeat this process to generate a year-end income statement.
Applying the accrual or cash method of accounting
Using the accrual method of accounting can help ensure your financial statements are accurate. The accrual method matches the revenue you earn with the expenses you incur to present a clear picture of company profit. However, the accrual method differs from the cash method.
Let’s look at an example. Riverside Landscaping bought $1,000 of sod in February, paid $2,000 in labor costs in March, and billed the Jones family $3,500 on March 20. The Joneses paid the invoice in April. Assuming Riverside spent $100 for overhead costs, we find they generated a $400 profit.
The accrual method matches Riverside’s revenue earned with expenses incurred to calculate revenue. The material, labor, and overhead costs and revenue posted when Riverside performed the work.
Cash inflows and outflows do not impact Riverside’s profit calculation. Let’s say that Riverside paid cash for sod in February (cash outflow) and received cash from the customer in April (cash inflow). The accrual method disregards cash movement and matches revenue with expenses in March.
Meanwhile, the cash method posts revenue and expenses based on cash inflows and outflows. As a result, revenue and expense transactions post in different months. For example, Riverside posts $1,000 in sod expenses when they pay cash in February. They post their $3,500 revenue when they receive cash from the customer in April.
How the income statement connects to the balance sheet and cash flow statement
The income statement is connected to the balance sheet and the cash flow statement. Net income in the income statement increases retained earnings in the balance sheet. Retained earnings represent company profits that fund future growth.
A business can pay earnings (dividends) to shareholders or retain business earnings. Retained earnings are a component of the equity section of the balance sheet. If your business issues common stock, the shares issued to investors post to equity.
Meanwhile, the statement of cash flow separates cash activity into operating, investing, and financing activities. You can use net income to calculate cash flow from operations using the indirect method.
You can use your income statements to help you control costs, increase sales, and generate higher profits. Analyze your report each month and use the data to improve your business.
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