The income statement, also known as the profit and loss statement, includes all income and expense accounts over a period of time. This financial statement shows how much money the business will make after all expenses are accounted for. An income statement does not reveal hidden problems, like insufficient cash flow. Income statements are read from top to bottom and represent earnings and expenses over a period of time.
The resulting difference between your income and your expenses is called your net profit—what is often referred to as the “bottom line.” This statement tells you if your business is profitable or not.
The format of the income statement is as follows:
Income – cost of sales = gross margin
Gross margin – fixed operating expenses = net profit
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.” The important thing to remember is that it does not always represent cash in hand. Sales are monies you have earned but not necessarily collected if you offer any kind of credit to your customer.
Cost of Sales
After the sales for your business are presented, 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.
The next number your income statement produces is the gross margin, sometimes called gross profit. This is the number you get when you take your sales for a given period and subtract your cost of sales. The gross margin is important for any business because it is 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.
After the gross margin is presented, your income statement shows your business expenses, sometimes called fixed expenses. Fixed 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.
Once you total all of your fixed business expenses, these are then subtracted on your income statement to produce your net profit. 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 relative expenses, it shows the profitability of a business and the amount of earnings made over a period of time.
The entire goal of your income statement is to align your sales with your respective costs to determine if you are making any money or not—your net profit. But sometimes you may 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 a piece of expensive equipment and expensing it across its useful life is called “depreciation.” Depreciation is known as the reduction in the cost of your equipment due to wear and tear over the passage of time. Once you expense depreciation on your income statement and you remove the amount from your earnings over time, you will then need to reduce the value of this asset.
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.