Imagine knowing exactly where your money is going and what’s driving your profits. That’s the power of an income statement! Let’s break it down together and make it simple to understand.
Keep reading to learn everything in detail about each component of the income statement.
What is an Income Statement?
An income statement is a financial document that shows a company’s revenues, expenses, and profit over a specific period. It’s often called a profit and loss (P&L) statement or an earnings statement. Think of it as a snapshot of how much money your business is bringing in, what it’s spending, and what’s left over.
Here’s what it typically includes:
- Revenue: Money earned from selling products or services.
- Expenses: Costs involved in running your business and generating revenue.
- Net Income (Profit): What remains after all expenses are subtracted.
Companies can prepare income statements for different timeframes, such as:
- Year-end statements for the latest fiscal year.
- Interim statements for shorter periods like monthly, quarterly, or semi-annually.
Most income statements also compare the current period’s data with prior periods to highlight trends and changes.
Why is the Income Statement Important?
Understanding your income statement can make a big difference for your business. Let’s break down five key reasons why every business owner should pay attention to it:
1. Improve Business Performance
An income statement helps you track your financial results against your plans. For example, if your revenue is lower than expected, you can adjust your marketing efforts or explore new sales channels to improve performance.
2. Gain Visibility into Profitability
With an income statement, you can see how your business is performing now compared to previous periods. For instance, a common size profit and loss account can show you whether your cost of goods sold (COGS) is increasing as a percentage of revenue. This kind of analysis is essential for making informed decisions and planning for growth.
3. Track Actual vs. Budgeted Spend
Did you spend more on marketing this quarter than you planned? Are operational expenses higher than usual? The income statement highlights where your spending aligns or doesn’t with your budget. For example:
| Category | Budgeted ($) | Actual ($) | Variance ($) |
| Marketing Expenses | 5,000 | 7,500 | 2,500 |
| Utilities | 1,000 | 950 | -50 |
This comparison helps you control costs and allocate resources better.
4. Meet Lender or Funder Requirements
If you’re applying for a loan or seeking investors, an income statement is one of the first documents they’ll request. It provides a clear picture of your revenue streams, profitability, and overall financial health.
5. Maintain Financial Compliance
Tax regulations require businesses to maintain accurate financial records. Along with a balance sheet and cash flow statement, your income statement helps ensure you’re meeting compliance requirements.
6. Support Tax Planning
Income statements identify deductible expenses, helping reduce taxable income.
Main Components of an Income Statement
Here are the main parts of an income statement and how they work together:
1. Revenue
This is the total amount of money a business earns by selling its products or services. But here’s the key revenue only includes money made from core activities.
Example:
If a company makes industrial machines, its revenue only includes earnings from selling those machines—not from selling a building or investments. Those other earnings go elsewhere in the income statement.
2. Cost of Goods Sold (COGS)
COGS, also known as cost of sales or cost of services, refers to the direct costs of creating or purchasing the goods or services sold during the period.
- For manufacturers: COGS includes the cost of raw materials, labor, and amortization expenses for producing goods.
- For retailers/wholesalers: COGS is the cost of purchasing products for resale.
- For service providers: It’s referred to as the cost of services and includes expenses directly tied to delivering services.
Important Note:
COGS doesn’t include administrative, marketing, or distribution costs.
COGS and Production
COGS fluctuates with production levels, making it a variable cost, unlike operating expenses (SG&A), which are fixed costs. For example:
- If a factory produces more units, the COGS rises due to increased material and labor needs.
- SG&A costs like rent or management salaries stay the same regardless of production.
Industries That Use COGS:
- Manufacturing
- Technology
- Construction
- Aerospace
- Transportation
- Telecommunications
- Agriculture and food
Retailers and wholesalers use the term cost of sales, while some businesses report both COGS and cost of sales if they manufacture products and engage in retailing.
Are Salaries Included in COGS?
Salaries directly tied to production—like factory workers—are part of COGS. But salaries for administrative staff, marketing teams, or management go under SG&A.
How is COGS Calculated?
Use this simple formula:
COGS=Raw Materials Costs+Labor Costs+Direct Costs for Production
Example:
- Raw Materials: $50,000
- Direct Labor: $30,000
- Direct Production Costs: $10,000
COGS = $50,000 + $30,000 + $10,000 = $90,000
How to Analyze COGS
COGS tells you your production costs. Subtracting COGS from revenue gives you your gross profit, which is the money left to cover fixed expenses, taxes, and dividends. COGS varies by industry, typically ranging from 20%–80% of sales. Compare your COGS to industry benchmarks to assess financial health.
Red Flags to Watch For:
If COGS is outside the 50%-65% range, it could mean:
- Expenses are misallocated.
- Costs are rising.
- Operational inefficiencies.
- Pricing strategies need improvement.
Need Expert Help?
If all these numbers and calculations feel overwhelming, Bestax is here to simplify it for you. From preparing income statements to analyzing COGS and profitability, we’ve got you covered.
3. Gross Profit
Gross profit is the difference between your revenue and the cost of goods sold (COGS). In simpler terms, it’s how much money is left after covering the direct costs of producing your goods or services. Here’s the formula:
GROSS PROFIT=REVENUE−COST OF GOODS SOLD (COGS)
Example:
- Revenue: $200,000
- COGS: $90,000
- Gross Profit = $200,000 – $90,000 = $110,000
Gross Margin:
You can calculate the gross margin to express gross profit as a percentage of revenue. Use this formula:
GROSS MARGIN=( GROSS PROFIT / REVENUE )×100%
Example:
- Gross Profit: $110,000
- Revenue: $200,000
- Gross Margin = (110,000 ÷ 200,000) × 100 = 55%
A gross margin of 55% means for every dollar earned, $0.55 remains after covering production costs.
4. Operating Expenses (SG&A)
Operating expenses are the indirect costs of running your business. These are also called selling, general, and administrative expenses (SG&A). They don’t relate directly to production but are essential for daily operations.
Examples of Operating Expenses:
- Rent and Utilities: Office space, electricity, water, and heating.
- Marketing and Advertising: Promotions, digital ads, and campaigns.
- Insurance: Business and liability coverage.
- Office Supplies: Stationery, software, and equipment.
- Maintenance and Repairs: Fixing or upgrading equipment and facilities.
- Employee Benefits: Health insurance, retirement plans, and perks.
- Accounting and Legal Fees: Professional services.
- Property Taxes: Taxes related to owning business property.
Why Operating Expenses Matter:
These costs help measure how efficiently a business runs. Keeping these expenses under control ensures more revenue flows to profit.
5. Operating Income
Operating income, also called operating profit, shows what’s left after subtracting operating expenses from gross profit. It reflects the profitability of core business activities.
PERATING INCOME=GROSS PROFIT−OPERATING EXPENSES
Example:
- Gross Profit: $110,000
- Operating Expenses: $40,000
- Operating Income = $110,000 – $40,000 = $70,000
6. Non-Operating Items
Non-operating items refer to gains or losses that don’t come from your core business activities. These include:
- Interest Income/Expenses: Earnings or costs related to borrowing or lending money.
- Dividends: Earnings from investments.
- One-Time Items: Asset sale profits, relocation costs, or legal settlements.
Why Separate Non-Operating Items?
Non-operating items can distort the true profitability of your core business. Showing them separately ensures clarity.
7. Earnings Before Taxes (EBT)
Earnings before taxes (EBT) is what’s left after subtracting all expenses, including interest and non-operating items, from total revenue.
EBT = Operating Income − Interest Expense + Non-Operating Income − Non-Operating Expenses
Example:
- Revenue: $200,000
- Interest and Amortization: $10,000
- Non-Operating Items: $5,000
- EBT = $200,000 – ($10,000 + $5,000) = $185,000
Why EBT is Important:
EBT excludes taxes, so it provides a clear view of profitability across businesses, regardless of location or tax rates.
Discontinued Operations
If a company has discontinued a product line, division, or subsidiary, it separates those results under “earnings before taxes and discontinued operations.” This ensures the income statement focuses on ongoing business activities.
8. Net Income
Net income, also called net profit, is what remains after income taxes are subtracted from EBT. It’s the ultimate measure of a company’s profitability.
NET INCOME=EBT−INCOME TAXES
Example:
- EBT: $185,000
- Income Taxes: $50,000
- Net Income = $185,000 – $50,000 = $135,000
Why Net Income Matters:
Net income helps assess overall profitability and is used to calculate important metrics like:
- Net Profit Margin:
Net Profit Margin=( NET INCOME / REVENUE)×100%
Example of Net Profit Margin:
- Net Income: $135,000
- Revenue: $200,000
- Net Profit Margin = (135,000 ÷ 200,000) × 100 = 67.5%
9. Earnings Before Interest and Taxes (EBIT)
Earnings Before Interest and Taxes (EBIT) is the profit a company makes from its operations before deducting interest and income taxes. It highlights how efficiently the business generates profits solely from its core activities, without considering debt or tax burdens.
Why EBIT Matters:
- Operational Efficiency: It shows how well a company generates earnings from day-to-day operations.
- Comparison Tool: EBIT allows comparisons between companies within the same industry. Since debt levels and one-time events vary across businesses, EBIT offers a clearer picture of operational success.
- Investor Insights: Investors use EBIT to evaluate whether to maintain or adjust their ownership in a company.
- Banking Decisions: Banks consider EBIT (alongside EBITDA) to assess a company’s ability to repay loans.
How is EBIT Calculated?
EBIT=Revenue−Operating Expenses (SG&A)−COGS
Example:
- Revenue: $200,000
- COGS: $90,000
- Operating Expenses: $40,000
- EBIT = $200,000 – $90,000 – $40,000 = $70,000
EBIT is often synonymous with operating income or operating profit, as it focuses solely on the company’s ability to generate profit from its operations.
Depreciation
Depreciation accounts for the gradual reduction in value of a company’s long-term assets, such as machinery, buildings, or vehicles. It reflects wear and tear and the asset’s decreased productivity over time.
How Depreciation Works:
- Tax Purposes: For tax reporting, depreciation spreads out the cost of long-term assets over their useful life, following government-set rates (e.g., by the Canada Revenue Agency).
- Financial Reporting: For financial reporting, companies may use alternative methods that better match the asset’s actual usage and decrease in value.
Methods to Calculate Depreciation:
- Straight-Line Method: Divides the asset’s cost evenly over its useful life.
- Declining Balance Method: Accelerates depreciation, recording higher expenses in the earlier years.
- Units of Production Method: Bases depreciation on the asset’s usage or output.
Is Depreciation an Expense?
Depreciation is recorded in COGS for production assets or operating expenses for non-production assets, depending on the asset’s use. It doesn’t involve actual cash outflow but reduces the book value of assets over time.
Impact of Depreciation:
- Tax Savings: Since depreciation reduces EBIT, it lowers taxable income, resulting in reduced taxes.
- EBITDA Analysis: Non-cash expenses like depreciation are excluded when calculating Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). This provides a clearer view of the company’s cash-generating ability.
How to Analyze an Income Statement
Analyzing an income statement can help you uncover valuable insights about your business’s financial performance.
1. Net Income Analysis
The net income is the bottom line of your income statement—it tells you if your business is profitable. Analyze the net income to:
- Determine if your company is making a profit.
- Track changes in profitability year over year.
- Benchmark your performance against competitors in the same industry.
Example:
- Year 1 Net Income: $50,000
- Year 2 Net Income: $70,000
If net income increases but at a slower rate than revenue, investigate what’s impacting your margins.
2. Net Profit Margin Analysis
The net profit margin helps you evaluate how much profit you’re keeping from each dollar of revenue. It’s calculated as:
Why It is Useful:
Net profit margin allows for better comparisons across companies or industries. For example:
- Your revenue might increase, but if your profit margin decreases, it could indicate rising costs or inefficiencies.
3. Vertical Analysis
Vertical analysis expresses each line item as a percentage of revenue. This approach highlights how different expenses affect your profitability.
Example: Vertical Analysis Table
| Line Item | Year 1 Cost | Portion of Revenue (Year 1) |
|---|---|---|
| Direct Labour | $15,000 | 7.3% |
| Materials | $54,000 | 26.3% |
| Total Revenue | $205,000 | 100% |
With vertical analysis, you can identify areas to reduce costs or improve efficiency. For instance, if materials consistently account for a large percentage of revenue, you might explore cheaper suppliers.
4. Time Series Analysis
Time series analysis compares income statement line items across multiple years. It provides insights into trends and helps explain changes in profitability.
Example: Time Series Table
| Line Item | Year 1 Cost | Portion of Revenue (Year 1) | Year 2 Cost | Portion of Revenue (Year 2) |
|---|---|---|---|---|
| Direct Labour | $15,000 | 7.3% | $11,000 | 6.3% |
| Materials | $54,000 | 26.3% | $44,000 | 25.1% |
| Total Revenue | $205,000 | 100% | $175,000 | 100% |
Why It is Useful:
Time series analysis shows where costs are increasing or decreasing. In this example:
- Direct labor costs decreased, improving profitability.
- Material costs also decreased but still represent a significant portion of revenue.
Income Statement Sample
Here’s an income statement template for reference
| Category | Details | Amount ($) |
|---|---|---|
| Revenues | ||
| Revenue Stream 1 | 3,500,000 | |
| Revenue Stream 2 | 2,000,000 | |
| Total Revenues | 5,500,000 | |
| Cost of Sales | ||
| Direct Cost 1 | 1,870,000 | |
| Direct Cost 2 | 1,402,500 | |
| Direct Cost 3 | 467,500 | |
| Direct Cost 4 | 233,750 | |
| Direct Cost 5 | 159,401 | |
| Total Cost of Sales | 4,133,151 | |
| Gross Profit | 1,366,849 | |
| Gross Margin (% of Sales) | 24.85% | |
| Selling, General & Administrative Expenses (SG&A) | ||
| Management and Office Salaries | 669,999 | |
| Advertising and Marketing | 135,000 | |
| Bad Debts | 10,000 | |
| Office and General | 75,000 | |
| Occupancy | 45,000 | |
| Professional Fees | 35,000 | |
| Insurance | 22,000 | |
| Repair and Maintenance | 17,500 | |
| Utilities | 5,600 | |
| Total SG&A Expenses | 1,015,099 | |
| Operating Income | 351,750 | |
| Interest and Depreciation | ||
| Interest | (103,900) | |
| Depreciation | (145,000) | |
| Non-Operating Items | ||
| Non-Operating Income | 25,000 | |
| Non-Operating Expenses | (35,000) | |
| Earnings Before Taxes (EBT) | 92,850 | |
| Income Taxes | 31,250 | |
| Net Income | 61,600 |
Quick FAQs
How can income statements be helpful?
Track revenues, expenses, and profitability for better decisions, benchmarking, and compliance.
Which accounts are on an income statement?
Revenue, COGS, operating expenses, interest, taxes, and net income.
What does an income statement show?
Revenues, expenses, and net income, reflecting profitability over a period.
How do you calculate net income on an income statement?
Subtract total expenses (operating, interest, taxes) from total revenue.
Is profit and loss the same as income and expense?
Yes, a P&L statement is an income statement showing revenue and expenses.
What is an income sheet?
Another term for an income statement, detailing revenues, costs, and profits.
What is accounting profit?
Net income on the income statement, revenue minus all expenses.
How to produce an income statement in QuickBooks?
Go to “Reports,” select “Profit and Loss,” set date range, and generate.
How to calculate interest expense on an income statement?
Multiply loan principal by interest rate, prorate for period, record as non-operating expense.
Disclaimer: The information provided in this blog is for general informational purposes only. For professional assistance and advice, please contact experts.
