An income statement is sometimes also called a profit and loss statement or earnings statement and is usually generated along with two other statements—the balance sheet and cash flow statement. Publicly traded companies are required to generate these statements at regular intervals, but even if you’re a sole trader, knowing how to read an income statement can help you make the most of your money. Here, we’ll break down what an income statement consists of, what it’s used for, and why it can help you to keep an eye on it.
What is an Income Statement?
An income statement breaks down the revenue and expenses a company earns and incurs over a specific period, resulting in a net income or net loss. It thus gives you an overview of revenue and expenses over a set period of time. It takes account of passive expenses like depreciation and amortisation in addition to active ones like office supplies and other operating expenses. Unlike the cash flow statement which tracks cash and cash equivalents, the income statement tracks everything that determines whether or not your business has made a profit. Like the cash flow statement (but unlike the balance sheet), it has a start and end date—it tells you whether or not your business has been profitable over the month, for example, or over the quarter.
What is an Income Statement Used For?
In addition to the obvious benefit of telling you whether or not you’re profitable, an income statement is also used to help generate the balance sheet and cash flow statements. Income statements can give you a detailed view of what expenses you’ve incurred over a given time, and reviewing income statements over a period of time will help you forecast your net profits. This can be particularly helpful if you want to make a large purchase sometime in the future, or if you’re seeking loans from investors. Even income statements that don’t show profits can prove to investors that an influx of cash might help your business; for example, if you need a lower cost distribution system, but are making a lot of revenue in sales, this will be reflected in the numbers.
Income Statement Structure
Income statements vary in complexity, depending on the size of business and their reporting needs.
- Basic income statements will list revenues at the top, followed by expenses, and finally, a total showing the net profit when expenses are subtracted from revenues. The expense amounts won’t have a minus sign in front of them, but it’s generally understood that they are being subtracted from the revenue amount.
- Income statements for larger companies sometimes are split into two sections that differentiate between operating and non-operating revenues, expenses, gains, and losses. Operating revenues and expenses are the expected revenues and expenses associated with doing business, while non-operating gains or losses might be interest income or legal settlement fees. It’s useful to separate the two because, in the case of a large company, it might otherwise be possible for non-operating costs to make profits look greater or worse than they actually are. Companies will often also have a line for “gross profit,” or profit that’s calculated by subtracting the cost of goods sold (the basic cost directly related to making whatever you’re selling) from the revenue earned, before listing administrative costs below. This can help a business to know how their overhead plays into their profit margin.
Reading Standard Income Statements
When you’re looking at an income statement, all this information tells a story. If you’re confused about what you’re looking at, the first thing to remember is that the net income is usually at the bottom, either in bold or underlined—this is the most important number. If it has a minus sign in front of it, is in parentheses, or is red, it means you’ve incurred a net loss for the length of time the income statement covers. If you have a loss, don’t panic—it’s not uncommon for businesses to have periods of loss once in a while, especially if they’re seasonal businesses or have incurred some unusual expenses, as long as they aren’t regularly losing money. But even if you’ve made a profit, it’s useful to look at the types of costs that offset your revenue, to make sure that the amount you’re spending on different categories of expenses makes sense for your business.
Here are a few things income statements can break down for you:
- How your expenses relate to your bottom line:
Before you take a look at your income statement, think about the types of expenses that are important to the operation of your business. If your income statement shows you expense categories that are much higher than you think they should be, it could be a sign that there’s an area you could cut back on expenses in the future.
- Whether your business is growing:
Checking income statements regularly can help you to determine whether you’re growing your business or whether you’re maintaining a steady income. If your goal is to grow your business, it may not be obvious from the net profit if your business is new, since some people reinvest in the business by improving equipment, buying more supplies, renting a better office, or other things that will affect your bottom line. If both your gross profit and expenses are growing, it’s a good sign that your business is growing too.
- If your marketing efforts are working:
If you start spending a lot on marketing, eventually you should be able to expect to see an increase in gross profits. Even if the marketing increases your overhead to some degree, the gross profit you see should increase even more with it. If it doesn’t, it’s a sign that you need to change your approach!
This isn’t an exhaustive list by any means; it’s up to you to look at the numbers to see whether or not they make sense, given your business type. Some businesses will spend a lot of money on equipment, while others (freelancers, for example) might not have as many expenses in that category. Even if you don’t understand them at first, trying to figure them out over time will give you a window into the way your business operates.