Before we answer “what is an income statement,” let’s back up a little in case you’re just joining us.
In our last post, “3 Most Important Types of Financial Statements Your Business Needs,” we had you stranded on a deserted island. (Go back and take a look…it’s a quick read and a good overview of the next few posts.) While on this island, you were able to keep running your business. But you were only allowed 3 financial statements. We talked about which ones you would need, and decided that:
The 3 most essential types of financial statements are:
- Monthly Income Statement (or “P&L”)
- Monthly Balance Sheet
- Cash Flow Report
While there are lots of other accounting reports that you could use to measure the financial health of your business, these 3 are the main ones that can help you stay on track…even if you don’t have anything else to look at.
The rescue boats are still on the way, so now we’ve got time to talk about each one individually. We’ll start with the first one: the Monthly Income Statement.
What is an Income Statement?
A Monthly Income Statement, commonly known as a “Profit and Loss Statement” or “P&L”, is a fairly simple report that lets you see at a glance how profitable your business is at any given moment.
This report is pretty flexible and can be run anytime you like. You can set the parameters to show you the last week, month, year, or several years. As we mentioned previously, however, we have found that generating it monthly (unless there’s a specific reason) works best to help you stay on top of your finances.
Your Monthly Income Statement is generated by a simple equation: Total Revenue – Total Expenses = Profit
What does an Income Statement show?
It’s a valuable report in that it shows you several things about your business at a glance, and you can quickly compare it to previous P&Ls to measure how your financial situation is improving (…or not).
Let’s look at each part of the equation (Total Revenue – Total Expenses = Profit).
“Revenue” covers all of the money you receive into your business from sales or services. Depending on the type of business you are in, there could be several sub-categories of revenue.
For instance, “Bob’s Bike Barn” might bring in revenue from:
- Bicycle sales
- Accessories (helmets, bike pumps, replacement tubes, etc.)
On his P&L, each of these revenue streams would be listed individually. In fact, each sub-category could be further broken down into more specific sub-sub-categories (i.e. “helmets”). The advantage of doing it this way is that you can easily tell over time if a particular area of your business is growing or falling behind.
If Bob noticed that sales of accessories had been steadily dropping over the last few months, he could make sure his employees are actively promoting those items or offer special coupons to encourage customers to spend more money there.
“Expenses” relate to everything you spend money on in order to keep your business operating. Like revenue, you and Bob both have multiple categories of expenses:
- Cost of Goods Sold (COGS) – These may vary depending on your level of production and amount of sales.
- Hourly Labor
- Operating Expenses (OPEX) – These are things that are constant regardless of revenue.
- Salaries & BenefitsTaxes
“Profit” (as you probably know by now) is everything that is left of your revenue after you have paid all of your expenses. You can improve how much profit your business ends up with by increasing revenue and decreasing expenses.
How to Read Your Income Statements
There are two standard ways of interpreting your Monthly Income Statements:
- Vertical Analysis
- Horizontal Analysis
Vertical Analysis is the method by which you organize each line of your Income Statement in a single column. Then each line item is listed as a percentage of its particular category.
For example, Bob’s Bike Barn listed several sources of revenue earlier. Vertical Analysis would allow Bob to quickly see which area of sales is contributing the most and which is the weakest link. That section of his Income Statement might look something like:
At a glance, it appears that Bob might want to keep an eye on his repairs department. (Especially if it represents a significant part of his expenses and payroll.) If it continues to underperform, he’ll need to find a way to draw more attention to that service. Or he may decide that his business operates better without it. That’s the kind of insights over time that Vertical Analysis of your Monthly Income Statements can provide.
Horizontal Analysis compares changes in a company’s financial statements over time. Where Vertical Analysis shows how individual line items relate to each other and is helpful within any given period to the business owner, Horizontal Analysis shows how those line items relate to themselves from one period to the next. It is more frequently used by investors and valuation firms in order to track a company’s performance.
Both methods are useful for giving you a complete picture of your Income Statements, and you should definitely take advantage of the ability to look at your business from multiple angles in order to make the wisest decisions possible.
(Harvard Business School Online’s article titled “How to Read & Understand An Income Statement” explains these analysis methods in greater detail if you want more information.)
A Few Words of Caution
We could stop answering the question “what is an income statement” there, but we wouldn’t be giving you the full picture.
While your Monthly Income Statement is an essential report, it doesn’t give you a full picture of your financial situation. For example, Income Statements don’t tell you everything about your business’ finances.
If you receive money for work you have not yet completed, you aren’t able to report it as “income.” Therefore, it would not show up as revenue on your P&L yet.
If you use raw materials to make something, you aren’t able to report the expense of those materials until you sell the thing you made with them. Which means it would not show up on your P&L right away.
So even though you definitely need to be looking at your P&Ls on a regular basis, don’t expect to be able to make the best decisions for your business without the help of the next two reports we’ll talk about…Monthly Balance Sheets and Cash Flow Reports.
Where to Get Help With Your Income Statements
If you want to dive even deeper, take a look at this article on Income Statements from Investopedia.
Articles are helpful, but sometimes in business you just need a real person to help you. We get it. That’s why we’re here! We’ve been guiding small business owners through all kinds of financial situations for over 40 years—even with their monthly bookkeeping. (We also specialize in helping Nonprofit Organizations, by the way. Nonprofits need to take advantage of these reports too!)
Whatever business you’re in, schedule a call with one of our financial experts today to learn more about how to maximize your finances and grow your business!