How to Understand The Different Elements of an Income Statement
An income statement is one of many types of financial statements for businesses. It details your revenue, expenses, and losses over some time. The ultimate goal of an income statement is to show your business' net profit or a net loss. Income statements can also be referred to as profit and loss statements or net income statements. With these statements in hand, you can see how profitable your business has been over a specified time.
An income statement is just one of three different types of financial statements used in business accounting, so you must understand it to learn about the health of your business. Here's how to understand the different elements of an income statement.
Learn the Information An Income Statement Contains
An income statement has many different numbers on it, all essential numbers to your business. It includes the following:
- Total revenue: Your total revenue is how much your business made.
- Cost of goods sold: This number equals the cost of the products or services your business sells to customers. It's the overall price you pay for a product before you sell it to your customers. This can include raw materials and even labor costs.
- Gross profit: The gross profit is the total revenue minus the cost of goods sold. This number shows you how much you would have made if there were no other expenses other than the cost of goods sold.
- Itemized expenses: Your income statement will list all of your business expenses, from office equipment to marketing costs. Many accountants also include the cost of fixed assets, while others separate their expenses into categories that include operating costs and non-operating costs, like taxes.
- Net profit: Net profit is also referred to as net earnings, and it tells you what your gross profit is by subtracting your expenses. This number tells you exactly how much money you made or lost.
Reading Your Income Statement
An income statement is meant to be read like any other document; you'll read it from top to bottom so you can understand where the final number (the net profit) came from.
1. Elements at the Top
The elements at the top of the income statement are the first numbers you need to find and subtract, including your revenue, cost of goods sold, and gross profit. While these numbers can tell you about the health of your business, they're not telling you the whole story about how profitable you've been.
2. Elements at the Middle
The elements at the middle of your income statement are more specific and detail all of your expenses. Typically, these expenses are forgotten about when you try to find out how profitable you've been in your head. However, these expenses are important to include in the equation because they tell you how much you've spent on other things, such as your digital marketing tools, office supplies, and even payroll.
Your accounting department is monitoring your business' spending and bank accounts daily to come up with the most accurate expenses.
3. Elements at the Bottom
The elements towards the bottom of your income statement are the most accurate depiction of your profits and losses. The last line of your income statement is where you find your net profit, the amount your company made from sales after deducting expenses.
The Structure of an Income Statement
The most important number on your income statement is at the bottom and requires a simple equation. Net income is equal to your revenue minus your expenses and losses. This equation is easy for accounting professionals to calculate since they have all of the numbers right in front of them, but it gets more complicated for global companies with many business segments, products, and services. It becomes even more difficult to understand if you've started acquiring other companies or merging with other companies.
Large corporations have a variety of operations, expenses, business activities, and regulatory compliance needs, which can lead to more complex income statements.
For example, an income statement may separate operating revenues, expenses, and gains from non-operating revenues and expenses while providing more details throughout the entire document to measure a company's different levels of profitability. By separating these areas of the income statement, you can easily identify how these numbers change over some time.
For example, if you have a high revenue but low gross profit, then you know you had high expenses, high gross profit, and low post-tax profit will show you a loss of earnings due to taxes and unusual expenses.
Using Income Statements
The main purpose of an income statement is to demonstrate your business' profitability to stakeholders, but it can also give your internal teams a clear picture of expenses. For example, suppose you look at income statements every quarter. In that case, you may find that expenses were higher during the holidays for one reason or another, allowing you to avoid that next year.
Income statements can be prepared at the department level, too, so you can check on your company management and see how different operations are performing.
Using your income statements, you can manage your business better and make decisions based on facts so you can push sales and become more efficient.
Lenders or creditors may also use income statements to get a clear visual of your cash flow. If you ever need a loan or would like to find funding for your business, one of the documents you’ll be asked for is your income statement. Make sure you are preparing these on an annual basis so you can provide everyone with the most up-to-date information.
Income statements may look complicated if you're not a numbers person, but they're quite easy to understand. Once you understand one income statement, you'll understand all income statements. Pay close attention to all of the numbers rather than just looking at the bottom for your net income. These statements can be overwhelming in the beginning, but once you begin to take your time with them and understand each section of it, you will have a stronger understanding of your business and ways to improve productivity at the same or lower cost.
Matt Casadona
Matt Casadona has a Bachelor of Science in Business Administration, with a concentration in Marketing and a minor in Psychology. Matt is passionate about marketing and business strategy and enjoys San Diego life, traveling, and music.
