The income statement lets us know how well we did over a period of time. Unlike the balance sheet, which focuses on a specific point in time, the income statement is based on a range of time. Usually this range is monthly, quarterly, or annually.
By examining the income statement, for example by month, we can determine where profits and expenses are coming from. We’ll understand if specific profits and expenses are increasing or decreasing. This allows us to make adjustments to our business, hopefully enabling us to remain profitable.
The Many Faces Of Profit
Profit goes by many names. Some of those names include:
- net income
- net margin
- gross margin
- operating income
- net profit
- earnings per share (public companies)
- profit per share (public companies)
We’ll look more closely at the meaning of profit and when it contributes to money you can deposit into the bank. But first, lets look at the structure of an income statement.
The Income Statement Structure
The income statement is composed of three sections. Starting from the top and working our way down, these sections are:
- Gross Profit
- Operating Profit
- Net Profit/Income
To arrive at gross profit, we start with our sales. Sales includes revenue from our products and services. Next, we subtract out cost directly related to building our products or rendering our services. This cost is known as cost of goods sold or COGS. If the business is strictly service based, this figure is called cost of services or COS.
COGS or COS is the cost taken out of your product or service revenue. Once these cost are subtracted from revenue, we end up with gross profit. It’s also referred to as above the line. Anything below gross profit is referred to as below the line. Why is this important?
Above the line refers to how much profit your product generated. Below the line is how much profit the business behind the product generated. If products are profitable but the business behind them is not, at the end of the day, you end up with a negative income. In this case, you’re paying the business to keep it running, since the business is unable to sustain itself. Not a good scenario. We need enough gross profit to pay below the line expenses.
To use an analogy, an employee’s salary is similar to a business’s product revenue. Whereas a business must take out product cost from its revenue, an employee must remove taxes, health, social security, etc. from his salary. For the business, removal of product cost creates a number called gross profit. For the employee, this number is called take home pay. However, both numbers are not what the business or employee can deposit into the bank.
The employee uses their take home pay to cover monthly bills. If their take home pay is more than their bills, the employee ultimately made a profit that month and can deposit money into their savings account. Going back to the business, its take home pay is its gross profit. But the business still has to cover expenses associated with running the business, such as rent, electricity, and office supplies. The business uses its gross profit to cover these expenses. What’s left over is similar to what an employee has left over, which the employee can deposit into the bank. For the business, there is still a little more work before they have cash, which can then be deposited into their bank.
We just touched on something formally called operating profit. This is the profit a business earns from the business it is in. In other words, from its operations. Once expenses related to running the business are taken out, we we have operating profit. I mentioned above that such expenses might include rent, electricity and office supplies. These expenses are also referred to as operating expenses.
Operating expenses let us know the cost of running our business. In contrast, COGS lets us know the cost of making our product.
As we move further down the income statement, we eventually arrive at the last line item, which is called net income or net profit. Once operating income (also called operating profit) has been determined, we need to subtract out taxes and interest expense (if the business has been financed). Since taxes and interest are not related to making the product or running the business, they get their own section. Subtracting taxes and interest from operating income leaves us with net income, assuming our business made a profit. If after subtracting taxes and interest our business made a loss, this last line is called net loss.
If we have a net profit, is that money we can deposit into the bank? The answer to this question is not so simple. It depends on the business structure or model and the type of accounting system being used.
If the business is using a cash based account system, net income is usually cash that can be deposited into the bank. However, most businesses don’t use cash based accounting. Instead, they use accrual based account, which applies the matching principal. In summary, the matching principal says expenses are matched against income for that period.
What exactly does it mean to match expenses to income? To simplify this answer, if you have an oddly large expense during one month, your business may show a loss for that month. But if you were able to spread that expense out over several months (thus depreciating it), it would provide for more even net income reporting. The matching principal allows us to do this. It can remove any wild swings in expenses and show more stability in our finances. An accrual accounting system is required to utilize the matching principal.
Bitesize Business School Q1 2014 Sales
Go behind BBS’s continued sales growth numbers in episode 3 of the Bitesize Business School Podcast.