Income Statements represent the financial activity of your business. They demonstrate the financial changes that occur over a given period of time, by comparing your revenues to your expenses. Income Statements calculate your Net Income (or Loss) and are your primary financial tool for identifying profitability.
Typically, Income Statements are produced monthly, showing the activity over the previous month as well as the year to date. But they can be produced as often as necessary. Some businesses even find it valuable to produce Income Statements on a daily basis.
Next we'll look at two common methods of organizing Income Statements. The Functional method is the more traditional method required by most financial institutions, while the Contribution Margin method is more management oriented, and will be explained in the section on Managerial accounting.
A Functional Income Statement is the traditional Income Statement most commonly used for financial reporting to banks, and other financiers. It's required for external auditing, and in publicly traded companies and is required in annual reports.
Gross Sales — These are the total sales made by your business during an accounting period (i.e. one month).
Returns and Allowances — This is where you record the return of faulty or unwanted merchandise by your customers, or discounts given for demonstration models or old stock.
Net Sales — This is the amount of money left over from sales after Discounts and Returns, to cover your business expenses.
Cost of Goods Sold — Cost of Goods Sold shows expenses associated with the buying or manufacturing process. For example, in retail it is the purchase price, and in manufacturing it is the cost of material, direct labour and factory overhead associated with production.
Gross Margin/Profit — Net Sales less the Cost of Goods Sold. This is the money left over to cover other costs.
Operating Expenses — These are the costs associated with the selling and administrative activities of the business. In other words, they include all costs other than the Cost of Goods Sold. i.e.
- Management salaries
- Bad Debts
- Legal Fees
Net Operating Profit (or Loss) — This is the profit (or loss) left over from sales after all business related expenses are paid.
Other Income — This is any income you receive from sources other than your regular business activities. For example, your business may own stock in other businesses or may sublet out part of your facility.
Other Expense — These are any expenses other than those resulting from your regular business activities. For example, you may incur legal fees resulting from a lawsuit. While the lawsuit may be a result of your business activities, it is not likely a regular or anticipated expense. Therefore, including it in your operating expenses would give you a skewed perspective of your finances.
Earnings Before Interest and Taxes (EBIT) — This is the profit (or loss) left over from sales after all expenses are paid, other than taxes.
Interest - Since interest is tax deductible, it is included after EBIT (Earnings Before Interest and Taxes) and before income taxes.
Income Taxes — Taxes paid to the government.
Net Profit after Taxes — This is the profit (or loss) left over from sales after all expenses are paid.
To allow you to more easily compare one Income Statement to another, try “common sizing” the numbers using the right-hand column to express each account as a percentage of net sales. For example, if your sales for August were $100,000 and you paid out $60,000 for labor, you would record your labour expenses as 60 percent on your Income Statement. We will discuss Common Size Income Statements later on in this chapter.
Contribution Margin Method
While the Functional Income Statement is the preferred method by lenders, investors, government, auditors, etc., it's not necessarily the most useful tool for managing a business. This is because it paints a financial picture from a “production” perspective, rather than from a “management” perspective.
A more management-friendly approach is the Contribution Margin Method. It provides the same basic information, but in this case, expenses are divided according to “sales” rather than by “function,” giving the numbers more meaning. Why? Because while production is essential, a business is driven by sales. For this reason, we'll use both methods in this program.
Revenues — (Gross Sales, Returns and Allowances, Net Sales) are the same as the Functional Method.
Variable Expenses — Variable Expenses are expenses that vary in relation to sales and production. If sales go up 20 percent, your Variable Expenses go up 20 percent. If sales go down 10 percent, your Variable Expenses go down 10 percent. The ratio won't necessarily be one to one, but the basic concept will hold true. When sales change, so will your Variable Expenses.
For example, any commissions you pay to your sales staff will vary quite closely to your sales. Your materials and packaging costs will likely vary with your sales as well.
Contribution Margin — The difference between your Net Sales and your Variable Costs is your “Contribution Margin.” This is the amount of money left over for covering your fixed expenses. It is important to note that as sales increase, all things being equal, your fixed cost percentage of sales will decrease. The difference is an increase in Net Profit.
Fixed Expenses — Fixed Expenses are costs that remain relatively fixed despite fluctuations in sales. If sales increase by 20 percent, for example, you will likely still need only one bookkeeper and your rent will likely stay the same. Of course, extreme changes in your sales may affect some of your Fixed Expenses. If sales increase enough you may need to hire a second bookkeeper or move into a larger facility, but these are one time, extreme cases. This does not make them Variable Expense.
You will find that there sometimes appears to be a grey area when trying to categorize some of your costs as variable or fixed. For example, marketing expenses may remain consistent throughout the year but if sales slide, you may decide to increase them in order to boost sales.
The solution is simply to use your best judgement when designing your Income Statement. For example, perhaps you will want to keep a portion of your marketing expenses fixed (such as a Google Adwords campaign), and another portion variable (i.e. 2 percent of sales will be spent on marketing). It's more important that the numbers are useful to you than it is for them to conform to some universal standard. If you need to make a few minor changes in order to apply for a bank loan, make the changes at that time, not now.
Net Operating Profit — Same as the Functional Method.
Net Profit Before Taxes — Same as the Functional Method.
Net Profit After Taxes — Same as the Functional Method.
Review your Income Statements from the past six months.
Timing — You should receive and review them regularly. Depending on the size of your business, quarterly may be an adequate schedule. How often do you currently receive them?
Do you receive them expediently? The longer you wait to review your financial reports the less up-to-date you are on your financial status, so try to have them available as soon as possible.
Accuracy — Mistakes are annoying, take time and resources to fix, and give you a false impression of your financial status. How accurate are your Income Statements?
Detail — Have you included enough detailed information on your Income Statements? How detailed should they be for your needs?
Layout/Format — Are your Income Statements simple and clear?
Now note any changes you would like to make to your current format.
Update your Income Statements with the changes you noted above. Then, save your updated Income Statement. If you do not currently have one, now is the time to make one.
Balance Sheet vs. Income Statement
While your Income Statements tell us if the operation of your business has been profitable during a given financial period, they provide only a partial view of your overall financial position. They do not show if your business is heavily indebted, if your customers pay promptly, or if your business is otherwise in good financial health.
That's where your Balance Sheets come in. Your Balance Sheets highlight the financial position of your business on a specific date. They show what your business “owns” and what it “owes,” along with your “owner's equity.”
Net Profit (or Loss) is the primary link between your Income Statements and your Balance Sheets. At the end of a financial period, it's calculated on your Income Statement and then either added to, or taken away from, the “owner's equity” on your Balance Sheet.
Together, these two reports paint a fairly complete financial picture of your business, but there is one more Financial Report to consider, especially if your business is experiencing rapid growth.