Financial Statements Part 1: Income Statement
The Income Statement or Profit & Loss is the first of the three primary financial reports. It shows the results of operation for a specific period of time. Hopefully the result will be a ‘profit’ but there is valuable information even in periods that result in a ‘loss’.
The report is organized by Income, Cost of Sales, Operating Expense, Non-Operating Income and Expense, Tax, and the resulting Net Income or Loss for each period reported. Typical time intervals for this report are monthly, quarterly, and annually.
Income can be reported on a single line but it is useful to break it into several accounts to isolate each unique type of revenue the company has. For our sample services company, billable sales are divided as follows:
To be able to measure the margin contribution of each revenue stream, it figures that the direct cost of generating that revenue should be divided into the same categories:
The difference between Total Income and Cost of Sales is the Gross Profit which means the excess amount billed for delivering your services during this period over what you paid for the people and tools required to do it. Gross Profit and its percentage of sales are the first measure of strength of a company and sets the limit of what funds are available to operate and manage the organization. An expected Gross Margin percentage will vary by industry with commodity product distribution at the low end and luxury items at the high.
Beyond Gross Margin are the expenses incurred to run the company. These are usually grouped as follows:
After subtracting these expenses from Gross Margin, you arrive at your Operating Profit:
Operating Profit is used to compare time periods against each other since it includes all of the regular income and expenses of running the business. The result can also be compared to other companies in the same industry to tell you if you are doing better or worse that your competitors.
The Other Income or Expense section is for items that do not directly result from the business operation, so they are separated on the Income Statement. These represent the impact of management decisions on investing, debt, and donations followed by income tax liabilities on earnings.
Operating Profit is adjusted by the net amount of these Non-Operating items to produce Net Income:
Also referred to as the “bottom line” because it is at the end of the report, Net Income (or Loss if the number is negative) is the litmus test as to whether a business is sustainable over the long run.