It takes a lot of knowledge to build your small business and that includes financial literacy. But some of the most important financial documentation you need to survive is basic, including an income statement.
An updated income statement helps owners understand and analyze the business’s profits and losses. The statement is a living document that shows whether a company is successful, and how to prepare an income statement can be simple once you know the essentials.
- An income statement demonstrates financial performance by showing all income and expenses your business incurs in a selected operating period.
- Preparing a statement is crucial for business owners to set goals, decrease expenses or increase prices, forecast upcoming trends, and find interested investors.
- A rudimentary equation for income statements is expenses subtracted from gross profits leading to net income, though many financial data points are used to arrive at that outcome.
What Is an Income Statement?
An income statement is a document showcasing and analyzing the profits and losses of your business. Also known as a “profit and loss statement” or “statement of earnings,” it includes items such as:
- Cost of goods sold
Many small businesses may choose not to create an income statement because they think their profits or costs are too small to analyze. However, scaling operations becomes extremely difficult if you don’t have historical information on your earnings, losses, and trends.
Business owners create income statements on a monthly, quarterly, or annual basis. If you are in the early stages, a monthly or quarterly may not be necessary. But it’s crucial, even with an annual statement, to regularly check on profits and losses and forecast accurately. Waiting a year for that may be too long.
An income statement answers a key question for businesses big and small: Is the business operating in the black (positive earnings) or red (negative earnings)? An income statement that shows healthy profits marks the company ready for growth; a statement showing extensive loss signals that operating costs must decrease or sale prices must increase.
How To Prepare an Income Statement
Income statements present a summary of all profits and losses incurred by a business in a selected timeframe. Preparing the document takes a lot of financial data to arrive at this holistic overview, including operating costs, net income, cost of goods sold, and more.
Many investors want to review income statements before investing in a business. If this form of capital is on the horizon for you, you’ll want to prepare income statements for the prior few cycles before fundraising.
The first line of an income statement acts as the first step in your income statement. Sales, also called “operating income,” is the total amount of money brought in from goods and services you sold. You may combine sales in one line or separate based on product line or other revenue-generating categories.
Sales may be shown as gross revenue or gross sales, though each represents the same information: how much you brought in from selling your product.
Calculate Cost of Goods Sold
Also referred to as “COGS,” the cost of goods sold is the money spent to produce the product or service for sale. A common example is the cost of materials to make a product. Add up the various costs directly related to production.
COGS appear right underneath the sales section of the income statement.
Profit is total revenue minus COGS. COGS is subtracted from total sales to arrive at gross profit, appearing at the top of the income statement under the first two lines. The money is “gross” as expenses have yet to come from it.
Operating costs or “operating expenses” is money spent not linked to your product or service. Costs in this section usually include office rent, payroll expenses, supplies, and utilities. Other operating costs that can show up on an income statement include marketing expenses and miscellaneous expenses.
Operating Income Before Taxes
At this point, your total expenses are subtracted from gross profit to create the operating income before taxes.
Your pretax operating income is important for equity analysis processes as outlined by the CFA Institute, as equity markets give valuations based on high or low-earning companies at this phase of the income statement.
The amount of taxes paid or expected to pay is subtracted from the operating income. It is necessary to take out taxes to arrive at the bottom line and demonstrate how much money the company lost or gained during the period.
Net income is the final line item on your income statement, as it shows whether you’re operating in the black or red. Your net income is the income left after subtracting all expenses from your gross profit.
Income Statement Example
|Cost of Goods Sold||$13,000|
|Operating Income Before Tax||$17,000|
Frequently Asked Questions (FAQs)
What are the three parts of an income statement?
An income statement breaks down into three essential parts: gross profit (top), operating expenses and tax (middle), net income (bottom). A simplified equation to arrive at net income is gross profit minus expenses.
What is the format of an income statement?
Income statements can exist in a vertical analysis, using percentages per line item of a base figure, or a horizontal analysis, using dollar amounts per line. A horizontal view gives a consistent picture of trends over time where a vertical analysis shows how line items relate.
What is a multi-step income statement?
A multi-step income statement is used when there is more than one line of business (LOB). This form separates operating revenue and costs from nonoperating revenue and costs for a greater understanding of profits and losses from each LOB.
What is considered an expense on an income statement?
Expenses on an income statement include everything apart from COGS. Expenses include administrative costs, such as employee salaries and bad debts, operational costs, such as rent and utilities, and miscellaneous costs.