There’s no simple analogy to describe an income statement —the insight it provides into your business is almost unparalleled.
It’s sort of like a report card that gives you a grade on your profits and losses over a particular period of time. But the income statement can also help assess your business’ strengths and predict future problems or opportunities. In other words, an income statement reveals both the results and the key drivers. It’s much better than a report card!
Suffice it to say, your income statement is the best indicator you have of how your business is doing and how it can improve. Let’s explore why.
What is an income statement and what does it look like?
An income statement calculates your business’ revenue, expenses, and net profit over a particular period of time. Also known as the profit and loss statement, it is one of the three major financial statements (in addition to the balance sheet and cash flow statement) you need to report your company’s financial performance.
Unlike the cash flow statement, the income statement accounts for all revenues and expenses at the point of transaction, rather than when cash is actually exchanged. So if you make a sale on credit, that will be reported on your income statement immediately, where you include that on the cash flow statement only when you receive the money.
Here’s the breakdown of the sections and components of the income statement:
Section I: Revenues and gains
- Operating revenue
This refers to the revenue you’re bringing in through the primary functions of your business. So if you run a sporting goods store, your operating revenue includes sales on baseball bats, basketballs, etc. Regardless of whether your customers pay in cash or credit, you include all these revenue-based transactions on your income statement.
- Non-operating revenue
Any revenue your business brings in outside of the core mission of the business falls under the non-operating revenue category. You might use business money to invest in the stock market and receive dividends from those investments. Similarly, individuals might invest in your business by purchasing shares of ownership. Those are two methods you can bring in revenue for your business without selling goods and services. Make sure to include these on your income statement as well.
Where operating and non-operating revenue are recurring or ongoing events, gains are the one-off transactions that bring in revenue for your business. Say that your sporting goods store has a climbing wall that you’re looking to get rid of to open up space for more inventory on the main floor. If you’re able to sell that climbing wall and bring in additional revenue for your business, that would be considered as a gain.
Section II: Expenses and losses
- Expenses linked to primary activities
Any expenses associated with the primary function of your business should be included in the income statement in this category. From to purchase inventory to pay for public services or pay employees, you need to ensure all of these expenditures are broken down in the income statement. These also include indirect expenses such as depreciation and amortization.
- Expenses linked to secondary activities
Outside of the core function of your business, you might incur additional expenses. For instance, if you take out a loan to procure additional inventory ahead of the summer season, you will need to pay interest on that loan. Since that transaction has an indirect effect on the sales of goods and services, it should be considered a secondary activity and listed on the income statement accordingly.
Occasionally, your business will likely face a one-off situation that causes a loss in money. The opposite of gains on the other side of the income statement, losses might occur if your business loses money buying and reselling a large item, like that climbing wall. Or any unfortunate event, like a lawsuit, that results in a loss of money would be included in the losses section of the income statement.
Why do you need an income statement?
Sure, the income statement is a required document to disclose your business’ financials—but how does it help you? With all of the information we just outlined properly input, your income statement will reveal important information about the state of your business and steps you can take to steer it in the most profitable direction.
With information about what is contributing to your expenses and revenue, you can determine where to expand your business and where to scale back. Your income statement can help you realize that the majority of your profits during the summer season come from the sale of baseball equipment. With that information on hand, you can make sure to increase baseball inventory for the next year and maybe downsize volleyball or another area where sales are lacking.
Because other businesses make their income statements public, you can compare yours with comparable companies to determine where you might be succeeding and where you might be struggling relative to your competition. This sort of benchmarking is always a useful practice, provided you’re making as much of an apples-to-apples comparison as possible. If you notice that a similar store in your local area had much more sales revenue than you did over a particular time frame, the income statement can help you figure out why. Perhaps they had more advertising expenses and you should consider running more ads next season.
Not only does your income statement help you determine a path forward for increasing future revenues, but it also can serve as a sort of advertisement for future investors. A strong income statement can be a vote of confidence for all different kinds of stakeholders in your business, from potential and current investors to banks and loan-granting entities. By demonstrating that your business can bring in revenue, you can encourage others to invest in your success, thereby bringing in even more revenue that you can use to expand and grow.
How to prepare an income statement: Single-step vs. multi-step
While, earlier, we discussed the different components of the income statement (i.e., operating and non-operating revenues and expenses), the breakdown of those components doesn’t necessarily need to appear on your income statement.
If you decide to create a single-step income statement, it will look relatively straightforward. With this approach, you’re essentially calculating net profit by subtracting expenses and losses from revenues and gains. While you would still list out each individual item in those categories, as seen in the example below from Accounting Coach, the different types of revenues and expenses are bundled together.
In a multi-step income statement, you have to subtract multiple times to arrive at your net income. Operating and non-operating revenues and expenses are listed separately. Here are the steps to calculate a multi-step income statement:
- Step 1: Calculate gross profit
Gross Profit = Net Sales – Cost of Goods Sold
- Step 2: Calculate operating income
Operating Income = Gross Profit – Operating Expenses
- Step 3: Calculate net income
Net Income = Operating Income + Non-operating Items
See what it looks like with the example from Accounting Coach below.
Both types of income statements have their value. You need to determine what information you need to make the most evidence-based strategic decisions for your company and assemble an income statement with that vision in mind.
Armed with the right information provided by the income statement, you can start positioning your business for sustained growth and optimum performance. If you own a sporting goods store, you can determine whether you need more cash-on-hand to replenish your inventory ahead of baseball season. Perhaps you need to apply for a loan from Camino Financial to ensure your company has the liquidity and the flexibility to pursue greater profits.
Whatever business you own, the income statement is an essential component to understanding your present and mapping out your future.