In my previous article, I introduced the concept of “Vital Signs” and drew a comparison between vital signs that are taken when you got into see your family physician and the three key financial statements for a business – the Balance Sheet, the Income Statement and the Cash Flow Statement. In my previous article I introduced the Balance Sheet. This article will address the second “Vital Sign,” the Income Statement which alternatively may be titled “Profit and Loss Statement,” “Operating Statement,” or “Statement of Earnings.”
While the Balance Sheet is a snapshot in time, reflecting the balance of the accounts at a specific moment, the income statement is a cumulative record of revenue and expense transactions from the start of an accounting period until the end of the accounting period. Income begins at zero at the very start of the period and then increases throughout the period. Accounting periods vary depending on the needs of the owner and are typically a month, a quarter or a year.
Business may choose to be on an Accrual basis or Cash basis of accounting. These will be discussed at length in a later article. Suffice for now to state that even if a business uses the cash basis of accounting, the income statement does NOT completely reflect the flow of cash in or out of the business because of various non-cash entries such as depreciation.
income statements have at least a revenue section and various expense sections such as cost of goods (service businesses an exception), selling, and administration. The revenue section reports revenue from operations, usually displaying the most significant revenue streams. For those businesses that sell products, the key product lines are displayed plus miscellaneous revenues such as shipping revenue, revenue from scrap, etc.
Several expense categories are reported after revenue. In the case of manufacturers, wholesalers, and retailers the first expense category is cost of goods sold (or manufactured). Service businesses do not normally report cost of goods sold expenses, but could under some circumstances. Cost of goods sold consists of the material, labor and overhead required to prepare the product for sales. A key element on the income statement is “gross margin” or “gross profit” which is revenues less cost of goods sold. This is key because it tells management how much it costs do get the products in a sellable condition excluding selling and administrative costs.
After gross profit, the support costs of selling the products or services and administratively managing the business are reported. Sales and Marketing expense are usually as separate expense category. This would be followed by General and Administrative expenses which include administrative items such as professional fees, office expenses, office salaries, depreciation, utilities, phones, etc.
Revenues minus all the expense categories noted above equal the bottom line – net profit from operations. There may also be other revenues and expenses for activities that are not part of the general operation of the business and these are shown below the net profit from operations. Obviously the owner wants net profit to be a positive number.