How to Prepare an Income Statement

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The income statement is the small business owner’s profit and loss statement for the business firm. It is one of the four financial statements that business firms usually prepare. It measures the profitability of the firm over a period of time. The income statement below is presented step-by-step so we can look at the profit or loss after each expense is deducted.

Line 1 is the gross revenue or sales figure.

This is the total of the amount of sales in dollars that the firm has made.

Line 2 is a $500,000 entry for cost of goods sold. This is the cost specifically associated with units of your product sold. Cost of goods sold is usually your largest expense. Subtract the cost of goods sold from gross sales to get gross profit (Line 3). After you get gross profit, you then subtract all of your other expenses from this number in order to generate your net profit.

From the $500,000 gross profit, the next expense you subtract is selling and administration expenses (Line 4). This $250,000 item represents your office expenses and sales commissions.

An important item that will merit more discussion is depreciation expense (Line 5). When you buy a building for your business or equipment, you depreciate it over a period of time. Depreciation is a non-cash expense and serves as a tax shelter so it is shown on the income statement.

After subtracting out selling and administrative expenses and depreciation, you arrive at your operating profit (Line 6). Operating profit is also called earnings before interest and taxes (EBIT), which in this case is $170,000.

After you calculate EBIT, the next step is to calculate interest expense.

Interest is what you pay on any debt your company has. In order to calculate the interest on the debt, you have to know the interest rate you are paying and multiply it by the principal amount of your debt. For this example, the interest amount is assumed at $30,000 and is stated on Line 7.

After subtracting your interest expense from EBIT, you get earnings before taxes on Line 8. Then, you fill in the amount you pay in federal, state, local, and payroll taxes on Line 9. The tax rate, in this example, is 40%. After you subtract that expense, you are finally at the earnings available to your common shareholders, which is stated on Line 10.

If you have investors in your firm or if you take a salary from your firm, Line 11 is where you record the draw or the dividends. Line 12, then, is the firm's net income or what you have left to plow back, or reinvest, into the firm in the form of retained earnings.

This is an example of a very simple income statement. The income statement of your company may be a little more complex and contain more line items. This statement should serve to give you the general idea of how a profit/loss statement, or income statement, works.

Income Statement

XYZ Company
Income Statement
For the Year Ending Dec 2009
2.Cost of Goods Sold$500,000
3.Gross Profit$500,000
4.Selling & Administrative Exp$250,000
6.Operating Profit(EBIT)$170,000
8.Earnings Before Taxes$140,000
10.Earnings Available to Common Shareholders
11.Dividends or Owner Draw$20,000
12.Net Income$64,000