Flock Free Nation

No nonsense information on small business.

May 2, 2011 - 3 minute read - Comments - entrepreneurship

Know Your Financial Statements - Part Two: The Income Statement

Unlike the balance sheet, the income statement summarizes activity for a period of time. This is most often a year, but can the owner specify any time period. It has three major sections: Revenue, Expenses and Net Profit.

Revenue A company’s revenue is the sales for the particular time period. Simple as that. For those of you that like buzzwords, this is referred to as the company’s Top Line, because it is the first line on the income statement.

Expenses Cost of Goods Sold The first expense line comes with the raw materials, shipping, labour and supervision of the work to make the products. If the company provides services, the term is Cost of Sales. A couple of things of note:

  • A key term is cost of goods sold. Any products that are produced and not sold go into inventory on the balance sheet. It’s strange, but if you have poor sales, the income statement doesn’t show the true story of how bad the situation is. For that you need the cash flow statement.
  • These costs are generally assumed to vary with Sales. Raw materials, shipping and some utilities behave this way. Labour and supervision generally don’t, unless you are paying by piecework instead of a wage.

A common measure used with this is called the gross margin. This is simply Revenue - Cost of Goods Sold. These results vary widely by industry, so for this to make sense, you need to compare yourself to others in your line of business.

Knowing your income statement gives you a deeper understanding of your business.

Sales, General and Administrative These are the fixed costs associated with running the business. They generally are the same whether you are operating or not. Sometimes these can vary with sales, however, with commissions or bonuses.

Depreciation or Amortization This cost comes from accrual accounting, whose main point is we account for an expense as we use the asset, not when we pay for it. For example, take a $100,000 building a business builds to run their business. If the expected life of the building is 20 years, the owners would record a $5,000 depreciation expense every year instead of a $100,000 expense in the first year. This is to allow for analysis without the extra complication of investment in the company. In addition, this isn’t a cash cost: we don’t have to write a cheque each month to Depreciation, and we account for this in the cash flow statement. When we subtract Sales, General and Administrative and Depreciation or Amortization from Gross Profit, we get the Operating Margin, or EBIT (Earnings Before Interest and Taxes). This measure shows how the company operates without the complications of financing (the amount of debt versus equity) and taxes (due to location and accountant skill). Like Gross Margin, Operating Margin varies by industry.

Interest This is the interest portion of the debt of the company. One note: Unlike dividends, that you pay owners, interest is tax deductable. It comes off before taxes are calculated. With dividends, the tax is paid beforehand. This phenomenon is known as an Interest Tax Shield.

Taxes This comes at the end. The government takes a piece of anything left over. If you have a negative balance between your sales and expenses, you don’t get a cheque from the government. You do, however, get to use these tax credits against future profits. These tax credits sometimes show up in the assets side of the balance sheet.

Net Profit Finally, when you take your sales and subtract all of your expenses, you are left with Net Profit. This figure is used in the cash flow statement as well as the balance sheet. The buzzword for this is the Bottom Line.

Tomorrow, we will look at the Cash Flow Statement.