An income statement is one of the most pivotal financial statements that explains the net income earned by your business during the accounting period.
While the balance sheet shows the net position of your assets, liabilities, and shareholders’ funds on a particular date, the income statement provides you with an overall picture of how much business you have done during a period.
However, understanding the profit and loss account and reading the income statement efficiently requires extensive knowledge.
As small business owners, stakeholders, or potential investors, you will need a basic understanding of how income statements are prepared and read efficiently.
In this article, we will deep dive into what is an income statement, what goes into an income statement, and 7 key considerations on how to read profit and loss statements efficiently.
What is an income statement?
An income statement for a small business is a financial statement that provides financial information such as revenue, expenses, gains, losses, and net income for the accounting period for which it is made.
Moreover, the Securities and Exchange Commission (SEC) also requires certain businesses to submit the financial statements to them, and the income statement is one of them.
An income statement, often referred to as a profit and loss statement. It provides information on the financial performance of a small business during an accounting period. At the same time, the balance sheet provides information on the small business’s financial position.
The preparation of an income statement is the first step in preparing the business’s financial statements. Once the net income is derived, the balance sheet is ready, and once the balance sheet is prepared, the cash flow statement is prepared.
As we have now understood what an income statement is, let’s move on to our next section on understanding what we need to prepare an income statement, i.e., what goes into an income statement?
What Goes into an Income Statement?
An income statement, as stated before, requires five components – revenue, gains, expenses, losses, and net income.
However, each part has further subcomponents, and knowing what falls in each category will help you accurately report your net income to your stakeholders.
So, let’s learn what goes into an income statement and consider them for small businesses.
Revenue
The total income earned by a small business during an accounting period is referred to as the business’s revenue. However, there are two broad categories of revenue to classify as operating and non-operating revenue.
Operating Revenue refers to the income earned by a small business from its principal activity. For example, a car manufacturer’s operating income will be the sales revenue generated from the sale of cars.
In contrast, Non-operating Revenue refers to the income generated from other than the principal activity of the business.
For example, when a car manufacturer sells some scrap material, the scrap’s income will be considered a non-operating revenue.
Cost of Sales
The cost of sales refers to the expenditure made by the small business to earn operating revenue. In the same example of the car manufacturer, when he makes expenditure on buying spare parts to manufacture a car will be considered as an operating expense.
Gross Margin
When you deduct the cost of sales from the operating revenue, you will get the gross margin. A high gross margin indicates that the business can retain more capital. And it has sufficient money to pay other expenses and debt obligations.
Non-operating Expenses
They are incurred to run day-to-day transactions of a business. For example, the salary of a sweeper or tea and refreshment expenses are non-operating expenses.
Earnings before Interest, Tax, Depreciation, and Amortization (EBITDA)
The EBITDA is derived by deducting non-operating or other expenses except for the interest, tax, depreciation, and amortization expenses from the gross margin. It indicates the overall performance of the business as it considers the net income before deducting interest, tax, depreciation, and amortization expenses.
EBITDA = Gross Margin – Non-operating Expenses except Interest, Tax, Depreciation, and Amortization
Or
EBITDA = Net Profit = Interest + Tax + Depreciation + Amortization
Additional Expenses
Additional expenses will include interest expense, income tax expense, gains or losses from the sale of exceptional items, and depreciation or amortization expense.
Net Income/Profit
The net income or the profit is the most crucial element of the income statement. It gives the outcome of the profit and loss statement. Net income shows whether your business was profitable or not. Net income is derived as follows:
The net income could be positive or negative – if it is positive, then it is a net profit, and if it is negative, it is a net loss.
The number one problem in today’s generation and the economy is the lack of Financial Literacy.” – Alan Greenspan (Past Chairman of Board of Governors of Federal Reserve System, USA)
Income Statement Sample
5 Key Considerations on How to Read Profit and Loss Statement Efficiently
Reading a profit and loss statement efficiently requires some basic knowledge of the income statement to understand the business’s flow and performance. Below are some critical considerations to understanding the profit and loss statement efficiently.
1. Understand the Total Turnover
The total turnover consists of operating and non-operating revenue. Having an idea of how much total operating revenue your business has made will make a massive difference in understanding the sales performance of the small business.
2. Check the Gross Profit Percentage
Understanding gross profit margin helps you make certain business-related decisions such as how to improve the operational efficiency of the company, how to improve the overall business performance, etc.
3. Look for the Highest Source of Revenue
From which source the company made revenue the most is a crucial aspect to understand. The key is to check if the company has earned revenue from any other sources.
4. Check the Exceptional Items Section
When a company incurs an expense that is exceptional and non-recurring, it is shown under the Exceptional Items section, such as legal settlements.
Reviewing this section will give you an idea that the company does not incur such expenses every year. However, it has to incur these expenses due to some extraordinary conditions.
5. Consider EBITDA
Profit before interest, tax, depreciation and amortization will give you the net income had these expenses are not incurred.
Sometimes, these expenditures are so huge that the net profit after deducting these three expenses will be significantly less and will give you a different picture of the performance of the business.
Conclusion
The income statement acts as a benchmark of how well the company did in a particular accounting period. You can also compare the results with your competitors. It is an indicator of your business’s ability whether it will be profitable in the long run or not.
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