An income statement, also known as a profit and loss statement, is one of several key financial statements that businesses and the self-employed use to assess the company’s financial performance.
The income statement, along with the balance sheet and the statement of cash flows, documents your company’s results for the year.
Use these tips to effectively analyze an income statement and make informed business decisions. If you just want to download our free profit and loss statement template, scroll to the bottom of this article.
Income Statement Formula
The income statement formula is connected to the matching principle of accounting, which posts revenue when it is earned and expenses when they are incurred to produce revenue.
Generally accepted accounting principles (GAAP) require a business to use the accrual method of accounting, so that revenue is matched with expenses in the proper month or year.
The matching process is reflected in the income statement formula:
Net Income = Revenue – Expenses
As an example, assume that Sterling Sporting Goods spends $30,000 to purchase 300 baseball bats as inventory in February. The cost of the baseball bats ($100 per bat) is posted to inventory, an asset account. If 50 of the bats are sold in March for $120 each, the $5,000 cost of the 50 bats is reclassified to cost of goods sold, an expense account. As a result, the $6,000 revenue from the March bat sales ($120 x 50 bats) is matched with the $5,000 March expense of purchasing the inventory. Sterling has a $1,000 profit on the sale, and the profit is posted to net income.
Relationship To Cash Flow
Using the accrual method also means that the statement of cash flows will not directly connect to activity in the income statement.
The accrual method of accounting posts revenue and expenses, regardless of when cash moves in or out of the business.
Using the baseball bat example, Sterling posts $6,000 of revenue in March, even if none of the $6,000 is received in cash. Accounts receivable is used to post any sales that are made on credit. In March, the revenue from the sale is matched with the expense of purchasing inventory, and a $1,000 profit is recorded. When cash is received, Sterling reduces the accounts receivable account and increases cash.
Connection To The Balance Sheet
The net income in the income statement is also posted to the equity section of the balance sheet. The balance sheet formula is:
Assets = Liabilities + Equity
At the end of each accounting period (month and year), Sterling closes the books by adjusting all revenue and expense accounts to zero. The total of revenue less expenses is posted to the net income, and net income increases the equity balance in the balance sheet. The $1,000 profit (net income) from the March bat sales increases Sterling’s equity.
The income statement accounts begin each new period with a zero balance, while the balance sheet amounts are carried forward from one year to the next.
Operating vs. Non-Operating Income
The income statement formula (Net income = Revenue less expenses)
is used to produce a single-step income statement, but many companies analyze business results using a multiple-step income statement since it provides more detail.
A multiple step income statement separates operating income and expenses from non-operating activity. Operating income and expenses are transactions related to the day-to-day operations of the business.
Sterling, for example, is in the business of selling sporting goods equipment through its retail locations. If, on the other hand, the firm sells a building for a gain, the gain is considered non-operating income.
Analyzing both operating income and non-operating income is important because successful companies must be able to consistently generate operating income to thrive over the long-term. Non-operating income is unusual, and a business cannot rely on non-operating income each year.
This single-step income statement template can be downloaded and used by any type of business, including the self-employed. It should be modified to include all of the relevant revenues and expenses that apply to the company. To fill out this spreadsheet, enter the applicable values in their respective cells. The total amounts will automatically populate based on the embedded formulas. An example worksheet is also included to help guide you through the process.