If you are starting a business, presumably you are doing so to make a Profit. Therefore, it is a cardinal sin to start a business to make a Profit, if you don’t in fact understand exactly what Profit is. Here we will walk through the basics of the Income Statement, which is the most fundamental of the several financial statements all businesses need to prepare and understand. Without understanding the Income Statement, it is not possible to fully understand what Profitability is.
The Income Statement has three basic elements: Sales (or Revenues), Expenses (or Costs), and Profit. In fact, Profit is just Revenues minus Expenses. So in a scenario where you start a business that has $100 in Revenues and $60 in Expenses, the Profit would be $100 – $60 = $40. This is a very simple example, but it gives you an idea of the basic elements of the Income Statement and how to determine the level of Profits.
The first element of concern is Revenues. As you can see in the example below, there is a reason that Revenues are often referred to as the “top line,” as they are literally the first line on the Income Statement.
As can be seen above, the next item on the Income Statement, after Revenues, is typically Cost of Goods Sold or Cost of Sales. These costs include all direct costs involved with providing or manufacturing the service(s) or product(s) that are generating your Revenues.
Once you subtract the Cost of Goods Sold (or Cost of Sales) from the Revenues, you arrive at Gross Profit. You may have heard the term Gross Profit Margin before, which is typically expressed as a percentage. So, in the example above, in 2007, the company generated $3,388,000 in Revenues and had Costs of Goods Sold of $1,839,000, which led to a Gross Profit of $1,549,000. This is a Gross Profit Margin of $1,549,000/$3,388,000, or 46%.
The following category of Expenses that must be considered is Selling, General and Administrative (S,G, &A) expenses. These are the Operating Expenses that allow you to sell your products/services and administer the business. As you can see above and below, SG&A Expenses often include such things as Advertising, Rent, and Utilities, among other costs that tend to be relatively fixed in nature – that is, they are costs that don’t vary directly with the level of Revenues.
Once the SG&A Expenses are subtracted from the Gross Profit, you arrive at the next level of Profit, which is typically called Operating Profit. You’ll also often hear it referred to a as EBITDA (“ee-bit-dah”), which stands for earnings before interest, taxes, depreciation and amortization. Don’t get hung up on all of these terms at this point, but just realize that when you hear someone talking about “ee-bit-dah”, they’re referring to Operating Profit.
In the following graphic, you will see that as you move further down the Income Statement, the next category of items to consider is referred to as Other Income and Expenses. This includes such items as Depreciation, Interest, and other non-SG & A or non-typical Revenue items, such as the gain on the sale of assets.
Once Other Income and Expenses are subtracted from, or added to the Net Operating Profit, whichever the case may be, you arrive at Net Income Before Taxes. Once Taxes are then subtracted from this amount, you arrive at Net Income After Taxes, which you’ll often hear referred to as the “bottom line” and now you can see why – it’s the last item on the Income Statement.
The example use above is simplified, of course. There are many nuances to understanding the Income Statement and financial performance in great depth. However, although simplified, the above example does give you the basics of what you need to know about how an Income Statement is structured, what the common important elements are, and how to arrive at and understand the Profits (or Income) of the business.
If you have questions or would like to discuss the nuances of how the Income Statement applies to your particular venture, don’t hesitate to contact us and/or leave a comment below, or in the top right corner of this post. Either way, we hope you have found this explanation of the Income Statement helpful and we’d love to receive your comments/thoughts/questions.