If you’re looking for a solid definition of the term “income statement,” then you’re in the right place.
Income statements are essential reports for any organization, as they give you a general overview of your business’ financial performance.
Today, we’ll cover everything you need to know about income statements, including a simple definition, essential elements, and how to read and understand an income statement.
Let’s start with a basic question.
What is an income statement?
An income statement is a financial report that showcases the profits and losses of an organization during a specific period (e.g., income statement for August 1 to December 31, 2021).
Income statements help you measure the overall financial health of your organization and give you a better understanding of your company’s performance.
This type of statement is also known as a “profit and loss statement” because it focuses exclusively on the financial status of your organization and tells you whether your business is actually turning a profit or losing money.
This provides managers, investors, and stakeholders with valuable insights to make better business decisions.
For example, if you discover that your business is losing money, you could design strategic plans to solve the problem, like increasing your prices or finding cheaper suppliers.
If you don’t analyze your finances constantly, making this type of decision would be hard, if not impossible.
Now, a typical income statement might look something like this:
As you can see, income statements cover a few key elements of an organization’s financial status, including:
- Net revenue: The total amount of money you made during a specific period.
- Capital gains: Any money you received from the sale of an asset that was over and above what you paid for it. (e.g., if you sold a company car for $30k when you bought it for $25k, you would have a $5k gain.)
- Expenses: All the necessary costs involved in your business’ operations (e.g., marketing expenses, rent, production costs, shipping and handling, etc.).
- Losses: Any income decrease that’s not directly related to your day-to-day operations (e.g., getting sued by a customer and losing).
- Net income: The general profitability of your business, after you have deducted all the expenses and costs involved during the period from your revenue.
We’ll cover these elements a bit more in-depth later, but first, let’s answer a major question.
Why are income statements so crucial for an organization?
An income statement is like your organization’s “blood test.”
It helps you understand how healthy or unhealthy your business really is.
A blood test helps your doctor spot potential diseases or conditions before they’re actually dangerous for you.
Blood tests also help doctors compare your body’s substances against normal ranges and understand whether your body is working right.
The same way, income statements help different people in your organization look for inconsistencies and problems in your business and create solutions before they start snowballing.
These reports also provide your stakeholders with valuable information that tells them if your business is worth investing in.
Let’s imagine that you’re an investor and want to compare two different businesses you’re thinking about investing in.
By exploring the organizations’ income statements, you can get a better picture of those businesses’ financials and start to figure out which of them represents a better opportunity for you.
Or let’s say that you’re the owner of an e-commerce company that sells sports shoes.
To understand your performance, you decide to analyze your annual income statement from the last period. Surprised, you discover that your expenses have been increasing over the last six months.
By breaking down your expenses, you find out that one of your suppliers increased costs by 50%.
Based on that information, you design a strategy to reduce your production costs and, thus, increase your profits — a decision that saved your business from bankruptcy.
Without a detailed income statement, that story could have ended very differently.
In short, income statements help you compare your performance against your financial standards and make decisions that are completely aligned with your strategic objectives.
Who uses an income statement?
Now that you understand what income statements are and why they matter, the question becomes: Who uses an income statement, exactly?
The short answer: Both internal and external users.
Let’s break them down:
The term “internal user” refers to any person that’s directly involved with your organization, including:
- Management: Managers and team leaders looking to better understand the business’ performance to make a specific decision.
- Board of directors: Legal representatives of the organization who are in charge of the financial management.
- Financial department: Accountants and financial advisors who need access to financial information for their daily tasks.
The term “external user” refers to any person who doesn’t form part of your organization, but can impact your financial situation and has access to your financial records.
- Investors: Any person or entity interested in funding your organization, expecting to get a positive return.
- Creditors: People or organizations you owe money to and want to know if you’ll be able to pay your debt.
- Competitors: Competing businesses in your industry looking for an opportunity gap.
- Stakeholders: Any person who is directly or indirectly impacted by your business’ operations.
- Auditors: Financial auditors who want to ensure your business complies with government regulations.
What can an income statement be used for?
Income statements are results-oriented. That is, they showcase financial data that has already been processed by your organization.
For example, an income statement won’t include a sales projection for the next month, but will showcase the sales and costs accumulated during the last month (or last year, depending on the period you’re analyzing).
This information can help you in different ways.
Let’s explore some of them:
As we covered earlier, one of the main objectives of an income statement is to serve as a financial document for managers and stakeholders to analyze.
By exploring the profits and losses of your business, these people can develop a better sense of the organization’s strengths and weaknesses.
As the late Peter Drucker once said:
“What gets measured gets managed.”
When key members can measure progress on a regular basis, they’re able to guide the company towards the objectives and mitigate risks and threats.
To prepare taxes, pay debts, and ensure your organization is financially stable, accountants and financial advisors need to understand how much you’re making, as well as the expenses involved with your operations.
Along with the other major financial statements, income statements help your accounting department get a clearer picture of your business’ health and make sure you’re meeting your financial responsibilities.
Risks and threats
Any business deals with risks and threats.
Whether it’s a new competitor, a strict regulation or law, or an external situation — like the pandemic caused by COVID-19 — you’ll always face different challenges that might threaten your organization’s integrity.
Income statements can help you spot these risks and threats early on and come up with potential solutions that prevent them from becoming a reality.
For instance, a dramatic decrease in your net income can be a red flag that may indicate something is wrong.
Or, if you notice that your expenses increased overnight, you might want to have a conversation with your team to explore the causes.
Analyzing your numbers often is crucial to anticipating risks and avoiding unpleasant surprises.
Like risks and threats, opportunities often present unexpectedly.
And, if you aren’t careful, you might miss out on huge opportunities for growth and improvement.
A good month can become a great year if you know how to read your numbers and use the momentum to scale.
For example, breaking a sales record could help you invest in more equipment, hire new talent, or diversify your capital.
If you don’t take action soon enough, you might end up wasting that extra money on activities that don’t move the needle.
This is a simple example, of course.
The point is that income statements can help you detect opportunities at the right time and help you make smarter decisions for your business.
Finally, income statements help you better plan the next period and organize your finances to cover all the coming expenses more effectively.
If last month you spent more money than expected, for example, you could restructure your processes and expenses to reduce costs next month.
Having a complete picture of your financial health can help you manage your resources more intelligently and get the most out of every working hour.
What are the essential elements of an income statement?
At this point, you already understand the basics of income statements, now let’s explore the different components that make them up.
First of all, we can divide income statements into two categories:
- Single-step income statement: Provides a simplified report of an organization’s financial status.
- Multiple-step income statement: Offers a more detailed and structured report, including some extra elements to calculate net income.
Let’s dig a bit deeper into each category:
Single-step income statement
As the name suggests, single-step income statements use a “single step” to calculate net income.
There’s a simple income statement formula you can use:
Net income = (R+G) – (L+E)
Here’s what the variables mean:
- R = Revenue
- G = Gains
- L = Losses
- E = Expenses
Let’s use an example:
- R = $100,000
- G = $30,000
- L = $10,000
- E = $5,000
In this case, the formula would look like this:
(100,000 + 30,000) – (10,000 + 5,000) = $115,000
In this example, your net income would be $115,000.
This type of income statement is pretty useful for small businesses, as they don’t need huge amounts of details to understand their financial situation.
Multiple-step income statements
Multiple-step income statements include additional information of an organization’s performance, including:
- COGS (Costs of Goods Sold): All the costs and expenses directly involved with the production of your products or services.
- Operating expenses: All the costs and expenses directly involved with your business operations but outside of direct production costs (e.g., accounting fees, marketing expenses, legal fees, etc.)
- Interest: Any interest payments owed on company debt.
- Depreciation: Any decrease in value of your assets or properties.
- EBT (Earnings Before Taxes): All your earnings before deducting taxes.
And some others.
To perform a multi-step income statement, you must follow three basic steps:
- Calculate gross profit: Start by deducting your COGS from your net sales (Gross profit = net revenue – COGS).
- Calculate operating margin: Deduct your operating expenses from your gross profit (Operating margin = gross profit – operating expenses)
- Calculate net profit: Finally, add in any non-operating income (e.g., capital gains) and deduct any non-operating expenses (e.g., losses, depreciation, interest, and taxes) to get your net profit (Net profit = operating margin + non-operating income – non-operating expenses).
This type of income statement is often used by organizations (e.g., manufacturers) that need a more detailed report of their performance.
How to read (and fully understand) an income statement
We can’t finish this guide without walking you through the process of reading and understanding an actual income statement in the real world.
Fortunately, it isn’t rocket science.
Here’s a quick process:
1. Understand what each element means
The first step to reading an income statement is to understand all its different components.
We’ve already covered some of them, but here’s a more complete list of all the elements you might want to include, depending on your financial model and specific needs:
- Sales revenue: The total revenue your business generated from sales during a specific accounting period.
- COGS: All the costs associated with the production or delivery of a product and/or service, including labor costs and materials used.
- Gross profit: Revenue – COGS.
- Operating costs: All the costs involved with the selling and distribution of products or services, excluding production costs.
- Operating profit: Your total income after subtracting operating costs from gross margin.
- Depreciation: The loss in value of an asset over its useful life.
- Interest income or expenses: Income or expenses derived from financial investments.
- Taxes: All the taxes you need to pay depending on specific rates attributable to your organization.
- Net income: Your total income after all the other expenses have been deducted.
Keep in mind; this is not a comprehensive list of all the elements you can include in an income statement. It does, however, cover some of the most important.
To get a better understanding of all these components, we suggest you take a look at our course “How to Read Financial Statements.”
This course will provide you with a more complete overview of all these components, as well as understand when they’re of vital importance.
2. Identify the type of statement you’re reading
Once you understand the different components of the income statement you’re reading, you need to identify whether it’s a single-step or multi-step statement.
The main difference between them is that single-step income statements cover just a basic overview of the organization’s financial operations, whereas a multi-step statement breaks down each element more in-depth.
3. Read from top to bottom
Income statements follow a logical sequence.
First, an income statement is broken down into different categories (e.g. sales revenue, gains, losses, and expenses). This structure will vary depending on the type of statement you’re reading.
You should start at the top and then follow all your way down to the bottom.
Each section will show you specific details about the finances of the organization.
In the following example, the “Gross profit” section breaks down things like the company’s revenue and COGS and calculates the gross margin.
The next section covers all the expenses involved and helps you understand how much money the business made after deducting operating expenses.
Finally, the “Net profits” section shows you the actual income the organization has after subtracting all the other costs and expenses.
By understanding the meaning of each component and following this linear path, reading an income statement becomes pretty straightforward.
4. Translate numbers into insights
Numbers and data are useless if they don’t help you take action.
The most important thing about reading an income statement is understanding what the numbers mean and translating raw data into actionable insights.
- Why did you make more money this accounting period than the last one?
- Why did your expenses increase so fast?
- What are you doing right?
- What are you doing wrong?
- Can you identify potential threats and opportunities?
- What specific actions can you take to improve your performance?
The answers to these questions will help you better understand your income statements and use them to make better and smarter decisions.
Income statements reveal the health of your business
They provide you with valuable information to manage your business and make better decisions.
Hopefully, now you understand how income statements work and how to read yours.
If you’re looking for further guidance on financial statements, check out our “How to Read Financial Statements” course. It’ll help you sharpen your financial skills.
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