Lesson 5: Income Statement

Lesson Overview 

In this lesson, you will:

Define the income statement, and

Identify the components of an income statement.

What Is an Income Statement? 

The income statement is another important financial statement and is used to track sales and expenses during a particular period. It is sometimes called a Profit and Loss, or P & L statement, and tells you if your business is profitable or not. It shows your income earned and expenses incurred. The resulting difference between your income and your expenses is called your net profit—what is often referred to as the bottom line.

The income statement format breaks down as follows:

Income minus cost of sales equals gross margin, gross margin minus fixed operating expenses equals net profit. Let’s break each of these sections down.

Income 

An income statement begins with money that you have earned from selling something. There are several different names given to the money you make selling products or services. Some companies call it revenue, sales, or income. It’s important to remember that it is not cash in hand in all cases. Sales are monies you have earned but not necessarily collected if you offer any kind of credit to your customer.

Let’s look at an example for this. Jennifer Williams owns a small boutique. She is preparing the Income Statement for the accounting period. She begins by calculating the revenue earned from the sales of her shop. For this accounting period she sold $51.00 worth of goods, so she enters $51.00 under the Sales section.

Cost of Sales 

The next section on the income statement details the cost of those sales. These costs are called variable expenses. Variable expenses represent the costs of doing business and might include direct labor, materials, and shipping. They usually increase with sales since they are the direct costs of delivering your products and services.

Using the example from the previous page, Jennifer Williams’ boutique spent $20.20 on materials, so she enters $20.20 under the Cost of Sales section.

Gross Margin 

The next number your income statement produces is the gross margin, which is sometimes called gross profit. This is the number you get when you take your sales for a given period and then subtract your cost of sales. The gross margin is important for any business because it’s the money you have left over to pay for any expenses of being in business and for making a profit. Many accountants look at this number as a percent of sales.

From our example, Jennifer Williams subtracts the Cost of Sales amount from the Sales amount. She deducts $20.20 from $51.00 and gets $30.80 for the Gross Margin.

Expenses 

The next item on the income statement is the business expenses, sometimes called fixed expenses. Business expenses are the costs of being in business. These might include salaries, insurance, rent, advertising, utilities, and interest payments. They usually do not vary with the sales level of your business. This is why they are called fixed expenses.

Using the example, Jennifer Williams needs to calculate her business expenses. She spent $5.00 on rent, $1.00 on depreciation, $0.20 on interest, and $0.60 on owner distributions for a total of $6.80 on expenses.

Net Profit 

Once you total all of your fixed business expenses, they are subtracted on your income statement to produce your net profit. Your net profit is the money left over after all expenses are accounted for and subtracted from the sales of your business. By aligning the sales of a business with its related expenses, it shows the profitability of a business and the amount of earnings made over a period of time.

Now, Jennifer Williams figures out her net profit. She subtracts her total expenses of $6.80 from the gross margin of $30.80 and gets a net profit of $24.00.

Figuring Depreciation 

Sometimes you make an investment in a large asset, such as a building or piece of equipment that costs a lot of money. If you would subtract the cost of this asset all at once, it would be impossible to tell if you are profitable or not. The reason for this is simple, these large assets produce value across a long period of time. This period of time is known as the useful life of the asset.

Taking a large cost, such as that of a piece of expensive equipment and expensing it across its useful life is called depreciation. Depreciation is the reduction in the value of your equipment due to wear and tear over the passage of time.

There are several ways to depreciate a piece of equipment. Some of the most common methods used to calculate depreciation are:

Straight-line,

Units-of-production,

Sum-of-years digits, and

Double-declining balance, which is an accelerated depreciation method.

As the equipment ages, you will expense depreciation on your income statement, which reduces the value of the asset over time.

Sample Income Statement 

Let’s take a look at a very basic example.

Sales are represented in the money you earned. This equals fifty-one dollars ($51.00). You will then subtract the Cost of Sales, which is twenty dollars and twenty cents ($20.20) in this example. The result represents a Gross Profit of thirty dollars and eighty cents ($30.80). Next, add up the expenses of the business and subtract the number from the Gross Profit. This represents a Net Profit of twenty-four dollars ($24.00).

Profitability over Time 

It is important to remember that your income statement presents sales and expense activities over a period of time as opposed to your balance sheet which shows your financial condition at a point in time.