An income statement summarizes your revenue and costs and shows your net profit in your business plan. Take a look at how a gift shop called Broad Street Emporium uses income statements to manage business finances. The figure shows the company’s annual revenues, costs, and profits for the most recent year as well as for the previous year. By comparing statements for two years in a row, the owners can see how their financial performance has changed over time.
The Broad Street Emporium income statement includes five sections. Each one provides important information about the company’s financial condition.
Income Statement Section 1: Gross revenue
The word “gross” has nothing to do with teenage jargon. In business finance, gross revenue refers to the total of all sales income collected by your business without subtracting any costs.
In the case of Broad Street Emporium, gross revenue comes from two major sources: money taken in via in-store retail sales and money collected through the store’s catalog sales.
Depending on your business, your revenue may come from sales of a single product or product line or from a number of different products and services. If you have more than one revenue stream, itemize revenues from each source so that you can see at a glance where your revenue is really coming from and then add the categories to arrive at your gross revenue.
Income Statement Section 2: Gross profit
In general, profit is the money that you get to keep after all the bills are paid.
Gross profit, also called gross income, is the first stage of profit. It equals gross revenue minus the costs of goods sold, which covers the costs directly associated with producing, assembling, or purchasing what you have to sell.
To Broad Street Emporium, costs of goods sold include the wholesale costs of the merchandise displayed on the gift shop’s shelves and in its catalog. To a service business, costs of goods sold include costs directly related to supplying or delivering the service. To a manufacturer, costs of goods sold include costs for raw materials and the labor, utilities, and facilities needed to put the product together.
You’ll have to make judgment calls regarding which expenses count as costs of goods. After you decide, keep your definition consistent over time so that as you monitor gross profit, you’re able to compare apples with apples.
Income Statement Section 3: Operating profit
After you have subtracted your costs of goods from your gross revenue to arrive at your gross profit, the next step is to calculate your operating profit, which involves several steps.
First you have to subtract from your gross profit your operating expenses, also known as general and administrative expenses or SG&A (sales, general, and administration) expenses. Under any name, these expenses include the costs involved in operating your business, including salaries, research and development costs, marketing expenses, travel and entertainment, utility bills, rent, office supplies, and other overhead expenses.
Next you need to account for something called depreciation expenses. When you purchase big-ticket items for your business — maybe a car to call on clients, a computer system, or even a building for offices, warehouse space, or other facilities — what you’re really doing is exchanging one asset (cash in the bank) for another asset (the car, computer, or building).
The business assets you acquire all have useful life spans, so one way to spread out the costs of these assets over the number of years they’re actually in service is to calculate and deduct depreciation expenses each year.
To calculate your operating profit (you might also hear it called operating income or EBIT, which stands for earnings before interest and taxes), you subtract your operating and depreciation expenses from your gross profit:
Operating profit = Gross profit @@ms Operating expenses and Depreciation expenses
On the example Broad Street Emporium income statement, operating expenses reflect staff salaries, advertising costs, and production and delivery of the store’s catalog three times a year. In addition, the company takes depreciation expenses for its storefront building, computer system, and delivery van.
Watch your overhead expenses like a hawk. They’re not tied directly to your products and services, so they don’t contribute directly to your revenue. But if they get out of line, they can quickly eat away at your gross profits.
Income Statement Section 4: Profit before taxes
Profit before taxes takes into account any income that your company made on investments of any sort and subtracts any interest expenses you paid over the statement period.
Profit before taxes = Operating profit + Investment income @@ms Interest expenses
The reason that you keep investment income and interest expenses outside your operating profit is because they result from money management and aren’t really part of your business operations. For one thing, the amount of interest you pay depends on how you’ve structured your company financially, not on the business itself. For another thing, interest absolutely, positively has to be paid on a strict and unforgiving schedule.
Income Statement Section 5: Net profit
Net profit (also called net earnings, net income, or bottom line) is what’s left after you subtract your final expenses from your total business income. As you read that sentence, you’re probably thinking, “Final expenses? We’ve already deducted every cost under the sun. What’s left to subtract?” How about taxes?
Depending on how you structured your company, your business may or may not pay taxes directly on its profits. If you’re a sole proprietor or if your business is a partnership, for example, your profits are funneled straight to the owners for tax purposes. But if your business pays taxes, you need to subtract those taxes before you state your final profit.