The Income Statement is one of the three key financial reports that you must understand as a business owner. It tells you how much money you are earning from your business activities – and how much those earnings are costing you, by detailing revenue and cost.
The Income Statement is also referred to as a profit and loss statement, so when someone mentions a P&L they are talking about the Income Statement.
The other two statements are the Balance Sheet and Cashflow Statements.
Unless you are a financial maven your eyes may glaze over as soon as I mention these statements. You might not have even made it this far in this post! But you can’t let that happen: the income statement provides critical information that you need to run your business as a machine.
This post covers the essentials, and we break down the Income Statement so you can use it to grow your business.
An income statement gives a detailed account of how much money you are making. It shows you where your money comes from, sources of revenue, and where it is going, expenses. And it shows you if you are making a profit (revenue is greater than expenses) or a loss (expenses greater than revenue).
A basic Income Statement Looks something like this:
Parts of an Income Statement
Income statements come in slightly different formats, the format we like, that we normally use, looks like the picture below:
I’ll explain each element here:
Revenue money entering the business in the period. In the example here we have just one source of operating revenue (revenue generated by your operations or “what you do” in the business, your signature program, your product). But we could have multiple sources.
Revenue that does not come from operations (say interest on a deposit in the bank) we put below in the “other income” section.
Note that income and revenue are the same thing.
Cost of Sales, Cost of Goods Sold, Direct Costs
Cost of Sales (COS), Cost of Goods Sold (COGS) and Direct Costs are all expenses that are incurred in the process of delivering your service or producing your product. (Note that we think all services should be products, so we talk in terms of products. If you deliver a service it is the same thing.)
If you make a product with four parts, for example, then you have one revenue item (you sell the product) and at least five direct expenses: each of the four parts and the cost of manufacture.
Then you have the marketing expense, and rent. Also, you took your big customer out to dinner, and you need to consider that as well.
If your are a lawyer the direct expense, cost of sales, cost of goos sold is the cost of lawyering: any lawyer’s time, paralegal’s time or any other labor that goes into delivering the legal results.
There isn’t one. Cost of Goods Sold (COGS) and Cost of Sales (COS) are the same thing. However, the COGS acronym is easier to pronounce – I think that is why most people talk about COGS instead of COS. Also, many people like to use cost of sales for a service and cost of goods sold for a product, but these are irrelevant nuances. (Feel free to tell your accountant that I said so).
The cost of running a business is an expense. And just like revenue, there are a couple of different kinds of expenses.
Cost and expenses are often used interchangeably.
We’ve covered the cost of sales and cost of goods sold: these are expenses that you incur when operating your business (and we’ll break these down even further in the next section of this blog post.
(Believe it or not, most entrepreneurs and small business owners are great at categorizing revenue as revenue.)
The challenge comes in classifying the expenses. It is important to know and work with the different types of expenses because there is generally much more activity in expenses so it is easier to make a mistake.
In the example above we’ve lumped expenses together into one line, but there are many categories that make up that expense line including:
- Sales, General and Administrative expenses: those expenses to run the business and sell the product.
- Travel expenses.
- Training expenses.
- Payroll for non-production workers.
And so on.
These expenses are more fixed in nature: you incur them regardless of the amount of product you actually produce (or service you deliver).
We often refer to these expenses as “overhead expenses.”
The role of, overhead, indirect expenses
You must spend money to make money: you will have marketing expenses, rent, a website, and so on; this line captures them.
You should manage SG&A differently than direct expenses. To reduce direct expenses, you look for efficiencies in production and delivery. To reduce overhead, you look for efficiencies in sales, marketing, and everything else.
Often SG&A expenses are fixed, meaning you can’t change them easily. Think of a five-year lease: there isn’t much you can do in year three to change the cost of that lease.
However, even fixed expenses eventually change – at some point, that lease will be up for renewal and you want to review that expense within the context of your overall profitability.
What is Gross Profit (AKA Gross Margin or Contribution Margin)
Revenue minus COGS or COS = Gross Profit, Gross Margin, and Contribution Margin.
This is the money that you make on the product before accounting for any non-production “overhead” expenses.
Contribution margin is another word for gross margin, and it is the one we use at SGM because it is easier to remember: contribution is the money left over that contributes to paying for your overhead and fixed costs.
The Break-Even Point Versus Contribution Margin
While the contribution margin is the money left over to pay for your overhead, fixed, or SG&A costs, the break-even point is where total revenue is equal to total expense, including overhead. As long as your contribution margin, or gross profit, is positive, then selling more products will help you pay for your overhead expenses and will eventually get you to break even and into net profit territory.
But before we get to net income, what are other income and other expenses
Other income is income that is derived from non-operating activities. Interest on a savings account might be “other income.”
Other expenses are expenses related to that income or things that don’t have anything to do with the business.
It is important to break these out for management reasons: you don’t want “other income” to influence your operating decisions. If this income were lumped in with revenue, you wouldn’t know whether you were making more money from interest on your savings account or your signature program.
And that brings us to: What is net income?
A company’s net income can be defined as the total profit of a company after deducting all costs and expenses from all revenue. The net income is also called net earnings, and it is an essential metric for you to understand.
This is profit and the line item that really matters.
But what are all the columns?
You probably noticed that there are more columns than just a list of revenue and expenses. Why? These are for comparison. They help you visualize, understand, and compare these numbers so that you can understand performance. These columns vary, but I’ll give you an overview of some of the basic ones:
The first column, labeled July 2022, shows your July results. If this were an annual report, the label would be the year.
The next volume over is the budget: this is what you expected to do in your budget, and the variance % shows how you compare to your budget, green is almost always good, and red is almost always bad.
Common size turns the numbers into a percentage of total revenue. This helps you visualize the importance of each line item.
YTD shows the results “year to date” for reference.
To Sum Up
Now, this is a blog post, not a finance or accounting course, so there is a lot that we are glossing over.
But this covers the essentials. You don’t need to be an accountant to read and understand your financial statements. In fact, your accountant may disagree with the way we look at financial statements. That is okay: we care about numbers for management, whereas accountants focus more on compliance.
Focus on understanding the critical components of revenue, contribution margin, direct expenses, break-even, and net income. These are the measures you need to understand and manage your profitability.