The Income Statement (or Profit & Loss Statement as it is also known) is probably the most widely used and reviewed financial report. There are good reasons for this and, while the Income Statement can't entirely describe the health of your small business, it can provide valuable insight into critical areas that can make a tremendous difference in the performance and success of your entrepreneurial endeavors.
In this episode of Up and to the Right I'll discuss how to get the most out of the Income Statement without investing hours of time or going to night school to understand the accounting behind it.
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Resources
Worksheet
There will be a financial analysis spreadsheet in Week 50's episode.
Tool of the Trade
Refer back to the 2016 Week 47 episode for a list of accounting tools. Let's get through week 50 and talk about new tools in Week 51; after all, we've all got a lot on our plates!
Reading Room
The book I was reading this week doesn't make the grade. Since we're rolling into the holidays anyway just spend a little of your reading time napping... you deserve it!
Show Notes
So much for reducing the time huh? I am committed to getting these down to bite size pieces!
Alright, I underestimated how much I had to cover when it comes to the Income Statement. Yeah... this episode is long... but the truth is that this is an important and probably the most widely talked about (if misunderstood) report of the three standard reports.
What is an Income Statement?
The income statement is, as its name suggests, a report that focuses on the sales (income) we receive from our customers and the effect of our expenses on our profitability.
Basically: Revenue (sales) - Expenses = Profit (loss)
There are three sections of a standard Income Statement (though your business may or may not require all three).
Gross Profit
The gross profit is the sales minus the cost of the material we sold (our cost). If we buy a square yard of cloth for $5 and sell it for $10 our gross profit is $5. Easy right?
Service based businesses that do not sell tangible products may not need to break this down since gross profit is 100% of sales.
My two cents here... most business decisions should not be based on gross profit. So, if gross profit isn't good enough... let's move on.
Operating Profit
Here's where the rubber meets the road as they say. We take our gross profit and subtract the expenses that aren't tied to a specific sale but are still required to operate the business. For example:
- Rent
- Employee Salary/Benefits
- Utilities
- Advertising
- Office Supplies
- You get the idea...
Once you've subtracted these expenses from our Gross Profit we get what we call operating profit or the profit after we pay for the materials to create our products and the expenses need to run the business.
Gross Profit is a great starting point for decision making because it reflects all of the income and expense related to manufacturing, selling and distributing your product to customers.
Net Profit
Finally we subtract taxes and add any interest earned on bank accounts to come up with Net Profit.
Honestly, I don't have much use for net profit. Taxes are a concern if you made operating profit already and the interest you earn on your bank account shouldn't be what makes your business profitable.
Why Should I Review It?
What items should you review on your income statement?
Income
Of course it's important to keep tabs on your sales. If you have more than one product line it can be helpful to see how each adds to your total sales.
If sales are not what you expect you can start focusing more of your attention to changes in your business that will increase your sales numbers.
Expenses
Cost of Goods Sold (COGS) - is very important because it is one of, if not, the largest expense and determines the Gross Profit which is the starting point for money used to run and grow our businesses.
Operating Expenses - some operating expenses are fairly fixed (rent is a good example) but many can be managed with some thoughtful changes saving business owners money that can be put to work growing/building the company.
Utilities can be reduced by putting conservation minded improvements or processes in place (i.e. occupancy sensors that automatically turn office lights off in rooms that aren't in use).
Advertising is easily adjusted but care must be taken to ensure that reductions in advertising do not have a significantly negative impact on sales.
Employee Expenses can be managed by reducing hours, eliminating overtime etc. NOTE: this is an example of cost reduction. Actions that negatively impact employees should be taken only after all other reasonable options have been eliminated IMO.
Taxes only happen after you have made a profit. If you have the fortunate burden of paying 'too much' in taxes you'll want to speak with a tax professional to find out if there are ways you can reinvest in your business or find other ways tax reduction options or just be happy that you are making so much money!
Takeaways
The numbers are your friend! Yes, they can occasionally feel like a cold shower and the tough love may not always feel good in the moment but they are a great way to make objective improvements to your business.
