An income statement, which shows your revenue after expenses and losses, tells a story about the performance of your business over a certain time period, such as monthly, quarterly or annually. Once referred to as a profit-and-loss statement, an income statement typically includes revenue or sales, cost of goods sold, expenses, gross profits, taxes, net earnings and earnings before taxes. If you want a detailed analysis of your business's performance, the income statement is the report you need.
What is an income statement, and why is it useful?
The income statement is one of three financial statements that are important to businesses of all sizes. The other two, the balance sheet and shareholder equity, go hand in hand with the income statement.
The income statement is often referred to as the statement of income, statement of earnings or statement of operations, but all of those terms mean the same thing: your profit and losses.
"The income statement reflects the income earned and expenses paid net of either profit or loss for a period," Mitchell Freedman, a certified public accountant at MFAC Financial Advisors, told business.com. "If you are selling services or merchandise, this is the measurement of how the company is performing."
Some small business owners may not think they need to worry about the income statement; after all, they know how much cash they have in the bank and how much is paid out. They also have a grasp on what they owe come tax time. But for any business owner who wants to identify expenses to cut or find new markets to enter, the income statement is invaluable. It can also help you stay on top of cash flow, which is the lifeblood of all businesses.
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An income statement helps you do the following:
Track the cost of sales
Income statements let you track different types of sales and show the cost of those sales. That information can be used to gauge if your expenses are too high or your prices are too low. Take a restaurant that incurs an operating expense related to food and labor. Those expenses are listed on the income statement and can give you an idea of whether your pricing is spot-on or it's time to raise or lower prices.
"If it shows you're not making enough margin to cover the rest of your expenses, you may have to increase prices or try to find a way to decrease cost of sales," Freedman said. Without income statements, business owners wouldn't know that.
Assess the sustainability of the business
The income statement can help you determine if your business will generate revenue over the long haul. It can also inform decisions about entering new markets, investing in expensive equipment and taking out a business loan. If your income statement shows prolonged periods of losses, you may think twice about investing in the operations. If profit is surging, it may be time to expand or enter new markets.
Prepare for tax time
Death and taxes are life's two certainties. The income statement can help with the latter. Whether you're filing your income tax quarterly or annually, you're required to provide a lot of information about your business. With an income statement, the tax total is all there. [Read related article: Do Small Businesses Pay Taxes?]
Plan and forecast
The ability to plan and forecast is made much easier with income statements. Being able to analyze the trends in pricing and sales over an extended period can improve your ability to predict how your business will fare in the future. That will, in turn, dictate your next steps. The longer you have an income statement, and the more detailed it is, the easier it will be to spot trends and analyze gross margin performance.
Who uses an income statement?
The income statement is an important document for businesses of all sizes. Nevertheless, many small business owners don't think they need to create one. This approach is risky, Freedman said. "Too many businesses operate at the seat of their pants and start putting internal controls and accounting systems in place to catch up with growth," he said. "That can be very dangerous."
What goes into an income statement?
The income statement includes several pieces of key financial information that's used to calculate profit and losses. They include the following items:
Operating revenue: Operating revenue includes all of the money the business earns from providing a service or selling goods.
Nonoperating revenue: This is revenue earned through noncore business activities, such as rent from a property the business owns or royalties from a partnership.
Gains: Often called other income, this is money the business made outside of its core operations. For instance, it could be money made from selling off land or an old vehicle.
Expenditures: Expenditures are money spent on goods or services to run the business. They are recorded at the time of purchase. Expenditures differ from expenses, which are typically offset over a period. For example, if you spend $10,000 on a copy machine and pay for it on the spot, that would be listed as an expenditure. But if you pay off the printer over several years, it's an expense.
Cost of goods sold: Known as COGS, these are the costs associated with selling your products. They include the materials to develop your goods and the labor to get them in the market.
Operating expenses: These are the costs not linked to the goods or services you're providing. They can include rent, office supplies and utilities, among other things.
Depreciation: These are expenses that are spread out over a long period of time. The value declines as the equipment or vehicle ages. Depreciation varies depending on the type of business you are operating.
Owner's draw: This is the money you take out of the business to pay yourself a salary.
Earnings before taxes: This refers to your income before you pay any taxes on it.
Gross profit: Calculated by subtracting the cost of goods sold from revenue, gross profit is the profit the company makes.
Net income: Net income is the income left over after you subtract all of your expenses from your gross profits. It's the most important line of the income statement. If your net income is positive, your business is doing OK. If your net income is negative, you may need to take a deeper look at operations. It's common for businesses just starting out to have a loss.
What are the types of income statements?
There are several types of income statements you can employ to stay on top of profit and losses, with varying degrees of complexity. For small business owners, the single-step income statement and the multistep income statement are the most popular.
Single-step income statement
A single-step income statement is the easiest one to create because it uses one calculation to ascertain the profit or loss of the business. Here is the equation used with a single-step income statement:
Net income = (revenues + gains) - (expenses + losses)
This type of income statement is simple to understand and easy to prepare, which is why it's commonly used by small businesses and sole proprietors that don't have several different sales lines. Companies that sell goods and services may opt to use the multistep income statement.
Multiple-step income statement
Used by businesses that sell tangible goods or have more than one line of business, the multistep income statement, as its name implies, uses multiple steps instead of one. With this type of income statement, the operating revenue and operating expenses are separated from the nonoperating revenue and nonoperating costs, losses and gains.
By separating operating income from nonoperating income, a business owner can get a deeper understanding of his or her operations. The calculations to determine profit or loss with a multistep income statement include the following:
Gross profit = net sales - cost of goods sold
Operating income = gross profit - operating expenses
Net income = operating income + nonoperating income
What is an example of an income statement?
While there are different types of income statements, they all include the key information listed above. Below is a sample income statement provided by SCORE, the nonprofit small business mentoring group.
Source: Image courtesy of SCORE
What are best practices for income statements?
Income statements are among the most important financial statements small business owners should maintain. But if you make a lot of mistakes, it could paint an inaccurate picture of how your business is performing – which is why it's important to follow these three best practices when creating your income statement.
1. Choose your reporting period.
Before you can even input your revenue or expenses, you have to choose the reporting period the information will cover: monthly, quarterly or annually. Unlike publicly traded companies, most small businesses aren't required to report their income statements quarterly, but updating the information regularly can be a great way to pinpoint trends in revenue and expenses.
2. Consider accounting software.
Thanks to cloud-based software, the days of jotting down your revenue and expenses in a physical ledger are over. These days, there are affordable, cloud-based accounting services for every size business. Going this route enables you to automate a lot of the work.
"If you use a cloud accounting program, it's a living, breathing document that can be updated in near real time," said Dennis Sherrin, a certified public accountant and past chairman of the Alabama Society of CPAs.
3. Seek out help from professionals.
Your income statement must be accurate for you to be able to assess your business's financial performance. For small business owners who are focused on growing their enterprise, crafting and updating an income statement may be daunting. If you fall in that camp, it's a good idea to call in the professionals.
"It's absolutely important that you have someone help you create your business's income statement according to the industry you operate in," Sherrin said, noting that a construction company's income statement is different from a retailer's, for example. "Having someone set it up consistent with the industry they are operating in allows them to compare and benchmark it" against rivals, he said.