An income statement is a financial statement that shows the revenues, expenses, and profits of a business over a set period of time such as a month or quarter. It’s often referred to as an “income and expense report” or a “profit and loss statement.”
It tells you how much money you made, how much it cost you to make that money, and if you made a profit. It’s also a snapshot of the health of your business, you can use it to see what’s working and what isn’t.
However, if you don’t know how to read an income statement, or understand what all of the numbers mean, it can be hard to understand exactly where your business stands.
In this article, we’ll take a look at the key elements of an income statement, explain how they work together, and show you how you can read your income statement to get a better picture of your company’s financial situation.
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The importance of knowing how to read an income statement
It’s important to know how to read an income statement because it’s the best way to understand your company’s financial health.
An income statement shows you how much revenue a company has earned over a specific period of time, and how much of that revenue is left over after expenses have been paid. It also shows you how well your company is doing compared with other companies in the industry. This gives you insight into what kind of growth or decline you can expect from your own business over time.
It can be very pivotal to fundraising and valuing your business as well.
The first step to understanding your income statement is getting familiar with all of the components.
knowing how to read an income statement is critically important when you’re looking to raise funding At that point, you’ll also have to learn how to share information with investors since you’ll demonstrate that your startup is earning adequate profits and income. And, is thus, worth investing in. Check out this video where I have explained in detail how to connect with your investors.
Components of an income statement
Income statements are typically presented in a table format with rows that represent different time periods and columns that represent different types of information. There are several key elements of an income statement which include:
Cost of goods sold
The cost of goods sold (also called COGS) is the cost of the inventory you sell during a given period. It’s important to include your COGS in your income statement because it’s an important metric for evaluating how much money you’re making.
Inventory is the total value of everything you have on hand at any given time. This includes both raw materials and finished goods, as well as anything else that goes into making or delivering your product or service.
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Net sales are an important component of an income statement because they show how much money a company generates on its products and services after certain discounts are applied.
To correctly calculate your net sales, follow these steps:
- Calculate the gross sales for the company
- Deduct sales discounts
- Deduct sales allowances and returns
- Calculate the net sales
Net sales are important because an income statement that only features gross sales can be very misleading.
Gross profit is the difference between the cost of goods sold and the selling price of those goods. It’s calculated by subtracting the cost of goods sold from the revenue earned by a company. The formula for gross profit is:
Gross Profit: Revenue – Cost of Goods Sold.
The gross profit percentage is calculated by dividing gross profit by revenue. The gross profit percentage tells you how much money a company keeps after paying for all its costs to produce, sell and distribute its goods. For example, if a company sells $1 million worth of products and spends $500,000 on labor, materials, and other costs associated with those products, its gross profit would equal $500,000.
Other income is a source of revenue that is not a direct result of your company’s primary activities. For example, an operator of apartment buildings may gain most of its revenue from rents. Though it may also bring in income from selling assets, coin laundry machines, application fees, etc.
Other income is typically classified as net or gross.
- Net other income refers to other income after it has been adjusted for any expenses connected with generating that revenue (such as employee salaries).
- Gross other income means that no adjustments have been made yet; this term is sometimes used in income statements when an organization has not yet determined how much money it will spend on generating new revenue streams.
Marketing, Advertising, and Promotion Expenses
Marketing expenses are the costs of promoting your business. This can include advertising on television or radio, hiring a public relations company, sponsoring a sporting event, or paying for billboards.
Advertising expenses are slightly different from marketing expenses because they relate specifically to the costs of advertising your products or services. For example, if you run an ad that promotes your business and mentions specific offerings you have available, this would be considered advertising rather than marketing. Other examples of expenses that fall under this category include:
- The cost of producing advertisements
- The cost of distributing advertisements
- The cost of promoting your business through public relations activities
- Any other costs related to marketing your product or service
General and Administrative Operating Expenses
General and administrative expenses are a company’s operating costs, which include things like salaries, office supplies and equipment, travel, entertainment and events, accounting and audit fees, legal fees, and other miscellaneous costs. These expenses are typically not directly related to the production of goods or services. These could include:
- Office rent
- Utilities and other expenses for the office
- Legal fees and accounting fees
Taxes on income from continuing operations
Taxes on income from continuing operations is the amount of taxes your company has to pay for the year, based on its income from continuing operations.
This is the total amount of income you made from continuing operations during the year, minus any expenses related to those operations—things like payroll and general operating expenses.
The tax rate is a percentage that’s applied to your company’s taxable income (the amount left after subtracting your business expenses).
EBITDA, or earnings before interest, tax, depreciation, and amortization is a measure of a company’s operating profit. EBITDA is calculated by adding back the interest expense, income tax expense, and depreciation expense that would have been deducted from net income (earnings) to arrive at earnings before interest, tax, and depreciation.
EBITDA is useful for comparing companies in different industries because it excludes items such as interest expenses and income taxes. These expenses are unique to each industry and therefore not comparable across industries or individual companies. For example, one company may pay a higher rate of interest on its debt than another.
EBITDA can be used by investors to compare companies because it allows them to focus on the operating performance of each company.
Depreciation & Amortization Expense
Depreciation & Amortization Expenses indicate how much a company has spent on depreciation and amortization in the past year, expressed as a percentage of sales.
Depreciation refers to the wear and tear that occurs over time in relation to the use of an asset. For example, if you have a laptop computer with a useful life of three years, at the end of each year, you’ll have spent 1/3rd of your laptop’s original value because it has aged by one year.
How to read an income statement
1. Determine what the bottom line is
You should first determine what the company’s bottom line is. If the figure is positive, it indicates that the business generated more money than it spent during the period and that it has the financial means to pay its workers and its debts.
When there is a negative number in front of the bottom line, if it is displayed in red, or if it is contained in parenthesis, this indicates that the business spent more money than it made, and it is critical to know why this occurred. This is commonly known as being in the red. You are losing money.
A net loss isn’t necessarily disastrous, particularly in the case of startup enterprises, which often have greater costs without corresponding profits in the first couple of years of operation. Similarly, cyclical enterprises such as agriculture see fluctuating yields from year to year and therefore be prepared for both prosperous and difficult years.
The most important thing is to keep an eye out for patterns that indicate the business does not have sufficient cash to cover its costs.
2. Identify income
Because there is only one figure that can be used to summarize all of the money that was made, the revenue part of the statement is often the most straightforward component. Growing one’s business’s income is often the quickest strategy to boost one’s profitability.
You should examine the business to see whether or not the income makes sense for the business. Be on the lookout for one-time gifts that aren’t sustainable since there is no assurance that the deal will occur again.
The next step is to search for one-time revenue sources that may not recur, such as unique events that don’t take place on a yearly basis. The best income is one that is consistent and predictable.
3. Evaluate costs
Expenses will normally consist of things like rent, insurance, interest, and supplies in addition to salary and pay.
It is important to note that the highest costs will differ depending on the sort of business you run. For the service type business model, the main expenditure will be wages, while for manufacturing businesses, the largest expenditure would be supplies and materials.
Think logically. Are there high wage costs associated with a company that has a low number of employees? Are the costs of materials extremely low for a manufacturing type business model? Are the fuel costs surprisingly low for a logistics company?
4. Look for patterns
The easiest way to read an income statement is to look at it in terms of trends and patterns. If you’re trying to figure out what’s going on with sales, for example, you can look at how much revenue your company has made over time and see if there are any trends. You can also look at how much profit the company has made over time and see if that’s fluctuating or consistent.
If you want to know what happened with expenses for a particular period, you can compare those numbers against previous periods. You might notice that your company spent more money on advertising than usual during a certain month or year, which could be an indication that something changed in terms of marketing strategy or budgeting.
Analyze the numbers on the statement using a rational frame of mind, and look for reasons to explain anything that doesn’t add up. In some cases, there will be explanations that make logical sense, in other cases, there may not. You should further analyze the business to identify any causes of discrepancy.
The income statement can be a critical part of your fundraising efforts. You’ll prove to your investors that your startup is generating revenues and is worth investing in thanks to its long-term growth prospects. Keep in mind that in fundraising, storytelling is everything. In this regard for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
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The Income statement: Things to look out for
Although the income statement covers a specific time period, most income statements incorporate data from the previous year(s) to make comparisons and show how your business has progressed over time. Compare the current reporting period to the previous ones using a percent change analysis.
- Are your primary income sources shifting?
- Are your sales increasing?
- Are you devoting more time to less lucrative activities?
- Have your costs risen dramatically?
- Is your business gaining or losing money?
Financial ratios and trends may help you spot potential financial problems that are not otherwise evident.
You can use an income statement to compare year-over-year performance and see how well your business is doing compared to last year, or you can use it to see how much revenue each product or service brought in. You can also use it to see if certain expenses are too high or too low, and then adjust accordingly.
Understanding and being able to read your income statement can equip you with the skills you need to chart your own path to success and make well-informed choices that benefit both you and the customers you serve.
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