How to read (and understand) an income statement

An income statement, also known as a profit and loss statement, provides a snapshot of your business’s profitability and operational results. Knowing how to read and understand it can transform how you manage your business finances. This blog breaks down the essentials, empowering business owners with the knowledge to analyze their financial statements accurately.

Apple made $89.5 billion in revenue in the fourth quarter of 2023, with the reported earnings per share declared to be $1.46.

We know this because public companies publish the details of their income statements quarterly. 

Now what if we asked you, how profitable is your business?

Your small business is thriving, but as you glance at the stack of your company’s financial documents, a knot forms in your stomach. You can’t read the income statement, so you can’t provide a data-informed answer to the question. 

Let’s change that for you with this blog. 

What is an income statement?

An income statement is your business’s financial story, and while it may be confusing, understanding it is not an insurmountable challenge.

Income statements, also known as P&L statements, are financial documents depicting a business’s profits and expenses over a specific period—monthly, quarterly, or yearly. They show all revenue and expense accounts, offering a clear picture of how much money the business made during that time. 

Fun fact

The first income statement was published in 1863 by the London and North Western Railway! It’s been helping businesses track their financial performance for over a century and a half!

The most confusion arises when comparing income statements with balance sheets and cash flow statements. Each offers a different vantage point of the same financial landscape. Combined, the three statements assess a company’s financial health and inform financial forecasts. 

Are income statements tied to other financial documents?

Short answer—Yes!

Long answer—Your income statements work best when you look at them alongside your balance sheet and cash flow statements.

A balance sheet shows what your business owns and owes at a specific time—like a snapshot. It tells you where you stand. Meanwhile, the income statement shows how you got to that point.

A cash flow statement reveals how much cash you have and where it came from. This is important, especially if you use accrual accounting. With this method, you might count income before you actually receive the money, which can be useful for predicting future earnings but not so helpful for knowing how much cash you have right now. The cash flow statement gives you a clear picture of your current spending power.

By reviewing and understanding all three financial statements, you’ll have a complete picture of your company’s financial health. This will help you plan for growth and avoid financial troubles.

To make it even simpler, think of it like baking a cake:

The balance sheet is like taking inventory of all the ingredients you have in your kitchen before you start baking. It tells you what you have on hand—like flour, eggs, and sugar—and what you owe, such as if you borrowed some sugar from your neighbor.

The income statement is like keeping track of all the steps you took while making the cake. It shows how much flour, eggs, and sugar you used and how much you have left. It helps you understand how you turned those ingredients into a delicious cake.

The cash flow statement is like checking your wallet to see how much money you have to buy more ingredients if needed. It tells you where your money is coming from and how much you have available to spend right now.

So, just like baking a cake requires knowing what you have, what you’ve used, and how much money you have left to purchase more ingredients, managing a business involves understanding your assets, expenses, and available cash to make informed decisions.

Parts of an income statement

Let’s start by breaking down the key elements of an income statement. 

Below, you’ll find a table that lists all the typical components. We’ll then go through each part in detail to help you fully grasp what they mean and how they contribute to the bigger financial picture.

Income Statement Amount (USD)
Sales Revenue $50,000
Cost of Sold Goods $20,000
Gross Profit $30,000
General Expenses  
Operating Expenses   
Marketing Expenses $3,000
Rent  $2,500
Utilities $1,000
Salaries and Wages $10,000
Depreciation Expense $1,500
Total Operating Expense $18,000
Operating Profit $12,000
Less: Interest Expense $1,200
Add: Interest Income $500
Net Income (Profit) $11,300

1. Total revenue

Total Revenue represents all the money flowing into your business. Think of it as the lifeblood of your company—the sum of every sale, transaction, or service rendered. 

As you scan your income statement, you’ll notice this figure proudly sitting at the very top, like the star atop a Christmas tree.

While it might be tempting to focus solely on the bottom line, your net profit, consider this: Total revenue plays a crucial role in the financial health of your business. Although cutting expenses can temporarily enhance your net profit, there’s only so much you can reduce before reaching a standstill. Here, total revenue steps in like a superhero, offering a sustainable path to growth that isn’t just about cost-cutting.

Why does it matter? Well, Total revenue sets the stage for determining your profit margin—a key metric that measures the balance between your spending and your earnings. So, the next time you’re eyeballing your income statement, give total revenue the attention it deserves.

Example: If you sell $50,000 worth of products in a month, that’s your total revenue.

Common pitfall: Failing to differentiate between gross and net revenue. Gross revenue includes all sales, while net revenue accounts for returns and allowances.

2. Cost of Sold Goods (COGS)

COGS is essentially the price tag of bringing your products or services to market. It’s the direct expenses you incur in the process. 

If you’re in manufacturing, it covers the cost of raw materials and labor. For retailers, it’s the wholesale price of the goods you sell. And in the service industry, it includes wages and supplies needed to deliver your services.

Here’s the kicker: COGS isn’t just about what’s happening now; it also remembers the past. Let’s say you invest in a crucial piece of equipment. Its depreciation—the decrease in value over time—gets factored into your COGS, reminding you of past investments.

In a nutshell, COGS isn’t just a line item on your income statement. It’s the backbone of your business, reflecting the real cost of doing business and reminding you of your investments over time.

Example: If your manufacturing costs are $20,000, that’s your COGS.

Common pitfall: Not including all direct costs can understate COGS and overstate profit.

3. Gross profit

After deducting your Cost of Goods Sold (COGS) from your total revenue, what’s left is your gross profit. It’s the amount you’re left with before factoring in other indirect expenses.

Your gross profit plays a significant role in shaping your net income. When you’re looking to boost your bottom line, your Gross Profit is where you’ll focus your efforts.

There are essentially two ways to increase your gross profit: either by raising what your customers pay or by cutting down on your COGS. The relationship between these factors is known as your gross margin.

Example: If your total revenue is $50,000 and COGS is $20,000, your gross profit is $30,000.

Common pitfall: Ignoring the impact of COGS on pricing strategy. Higher COGS can shrink your profit margins.

4. Operating expenses

Operating expenses, also known as indirect costs, are the backbone of your business expenditures. 

These can be divided into two main categories: fixed expenses and variable expenses.

Fixed expenses remain constant from one reporting period to the next. Take rent, for example—it’s the same amount you pay every month, regardless of how your sales are performing.

On the other hand, variable expenses fluctuate with your business activities. Think of marketing expenses—they increase or decrease based on your promotional efforts and sales volume.

Within your operating expenses, you’ll find both overhead costs and operating costs. Overhead represents the essential expenses you incur just to keep your business operational, such as rent and utilities. Operating costs, on the other hand, rise and fall in tandem with your sales.

When it comes to trimming expenses and bolstering your bottom line, operating expenses are the second stop after tackling COGS. Simple measures like optimizing utility usage, implementing cost-effective marketing strategies, or maintaining equipment to reduce wear and tear can all contribute to lowering your operating expenses.

Example: Your monthly rent is $2,500, and marketing expenses are $3,000.

Common pitfall: Overlooking variable expenses can lead to budget shortfalls.

5. Operating profit

Operating income, sometimes referred to as operating profit, is what remains from your gross profit after subtracting your operating expenses. This figure represents the income generated from your core business operations, excluding non-operating expenses like interest payments and taxes.

Why does operating income matter? 

From the perspective of accountants and financial analysts, operating income is a crucial metric for assessing your company’s profitability. While net income factors in all expenses, including non-operating ones, operating income provides a clearer picture of how well your business is performing on a day-to-day basis.

To put it into perspective, think of it in terms of job roles: You, or your company’s managers, handle total revenue, COGS, and operating expenses—the nuts and bolts of running the business. 

Meanwhile, your accountant tackles tax burdens and debt management—the financial intricacies that affect your bottom line in different ways. Day-to-day activities directly influence operating income, while tax returns and loan agreements operate on a separate track.

Example: With a gross profit of $30,000 and operating expenses of $18,000, your operating profit is $12,000.

Common pitfall: Confusing operating profit with net profit, which includes non-operating expenses.

6. Interest expense and interest income

Your interest expense represents the amount you pay to cover the interest on your small business loans or lines of credit. It’s the cost of borrowing money to fuel your business operations. Additionally, if your company holds investments in stocks, any interest or dividends received are also reported here as income.

After addressing your COGS and operating expenses, interest expense is the next area you’ll scrutinize to support your bottom line. 

Seeking guidance from your accountant can be invaluable in this process. They may suggest strategies such as debt restructuring or prioritizing repayment of higher-interest debts to optimize your financial position.

As a small business owner, it can be tough to afford a full-time accountant on an expensive annual package or a part-time accountant with unpredictable hourly rates. To your delight, CoCountant lets you hire a dedicated accountant for a fixed monthly price that you won’t be able to say ‘no’ to!

Interest income, on the other hand, represents the earnings your business receives from investments, such as interest on savings accounts, certificates of deposit (CDs), or bonds. It’s essentially the flip side of interest expense—while interest expense reflects the cost of borrowing money, interest income reflects the returns on your investments.

Understanding your interest income allows you to optimize your investment strategies, making informed decisions about where to allocate your funds for maximum returns. It’s an essential component of your business’s financial health, providing a steady stream of income to support your operations and growth initiatives.

Example: If you pay $500 in loan interest but earn $500 from investments, these amounts offset each other.

Common pitfall: Not accounting for all interest expenses can distort financial results.

7. Net income

Net income—those two words hold immense weight in the world of business. It’s the ultimate scoreboard, the final verdict on your financial performance.

Think of net income as the heart of your business—it pumps lifeblood into your operations, fueling growth and sustainability. After all the revenue has been counted and every expense has been settled, net income is what’s left standing. It’s the profit or loss you’ve earned after the dust settles.

Aside from being a crucial metric for investors and stakeholders, it’s also a barometer of your business’s health and resilience. A positive net income signals profitability and success, while a negative net income calls for reassessment and strategic adjustments.

Example: If your total expenses are $38,000 and your total revenue is $50,000, your net income is $12,000.

Common pitfall: Misclassifying expenses can impact the presentation of expenses on the income statement.

By understanding these components and avoiding common pitfalls, you’ll be better equipped to analyze your income statement and make informed financial decisions.

How to analyze and understand your income statement

Now that we’ve explored the different components of an income statement, let’s take a closer look at how you can analyze and understand this crucial financial document. 

Understanding the dynamics of your income statement can significantly influence how you steer your business toward stability and growth.

Types of income statements

Income statements come in two primary formats, each serving different purposes depending on the complexity and needs of the business:

Single-step income statement: 

This simpler format is typically used by smaller businesses with straightforward operations. It directly subtracts total expenses from total revenues to calculate the net income, making it easy to prepare and understand at a glance.

Multi-step income statement: 

Preferred by larger, more established businesses, this format provides a detailed breakdown of how the net income is arrived at through several steps. It separates operating activities from non-operating activities, offering a granular view of revenue sources and expense categories.

Methods of analysis

To extract meaningful insights from an income statement, you can employ two main analytical approaches:

Vertical analysis: 

This method involves expressing each item on the income statement as a percentage of a base figure (like total sales). For example, it might show how each expense contributes to total sales. This makes it easier to compare companies of different sizes or to benchmark against industry standards. It helps identify what areas are costing the most and how they’re changing over time.

Horizontal analysis:

This approach compares the same items on the income statement over different periods. By looking at how figures change year over year or quarter over quarter, you can identify trends, growth patterns, and potential red flags in the finances. It’s particularly useful for tracking the progress of strategic initiatives or the impact of market changes.

Tips for small business owners and entrepreneurs 

When analyzing an income statement, consider these practical aspects to gain a comprehensive understanding:

  • Revenue streams: Identify and assess the stability and growth of different revenue streams. Are there fluctuations that need to be addressed?
  • Expense management: Look at how expenses are managed relative to revenue. Are there areas where costs can be reduced without impacting product or service quality?
  • Profitability metrics: Pay attention to key profitability indicators such as gross margin, operating margin, and net margin. These metrics are critical in assessing the efficiency of your business operations and its ability to turn sales into profits.
  • Integrative analysis: Combine vertical and horizontal analysis to thoroughly understand your business’s financial health and operational strategy effectiveness. This comprehensive approach not only provides a current snapshot of your financial status but also outlines a strategic path for future growth and sustainability.

The bottom line

Understanding your income statement is essential for making informed decisions and driving your business forward. By regularly analyzing this financial document, you gain valuable insights into your business’s performance and can identify areas for improvement.

With CoCountant’s personalized accounting services for small and growing businesses, we ensure that your financial data is accurate and actionable, so you can use it to strategize and optimize your financial operations. 

FAQs

What is an income statement?

An income statement, also known as a profit and loss statement, is a financial document that summarizes a company’s revenues, expenses, and net income over a specific period, typically monthly, quarterly, or annually.

Which accounts are found on an income statement?

Accounts commonly found on an income statement include revenue/sales, cost of goods sold (COGS), gross profit, operating expenses, interest expense, and taxes.

How to prepare an income statement?

To prepare an income statement, start by listing your revenue at the top, then deduct your cost of goods sold to calculate gross profit. Next, subtract operating expenses, interest expense, and taxes to arrive at net income.

What goes on an income statement?

An income statement typically includes revenue, cost of goods sold, gross profit, operating expenses, interest expense, taxes, and net income.

What does an income statement show?

An income statement shows a summary of a company’s revenues, expenses, and profitability over a specific period, providing insight into its financial performance.

How to do an income statement?

To create an income statement, gather financial data such as sales, expenses, and taxes, organize them into categories, and calculate the net income by subtracting expenses from revenue.

How to make an income statement?

Making an income statement involves organizing financial data into categories such as revenue, expenses, and taxes, and calculating the net income by subtracting expenses from revenue.

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Disclaimer

CoCountant assumes no responsibility for actions taken in reliance upon the information contained herein. This resource is to be used for informational purposes only and does not constitute legal, business, or tax advice.  Make sure to consult your personal attorney, business advisor, or tax advisor with respect to believing or acting on the information included or referenced in this post.