Understanding an Income Statement & How to Prepare One

Understanding an Income Statement & How to Prepare One
As a business, it’s crucial to have an income statement. Find out what it is, how to prepare one and income statement examples. Visit Square today.
by Square Aug 31, 2021 — 5 min read
Understanding an Income Statement & How to Prepare One

If you’re a business owner, it’s important to always have a handle on your financial situation. There are plenty of ways you can do this, such as keeping a balance sheet, a cash flow statement and also an income statement. Income statements form a crucial part of your financial analysis, and also gives you a great glimpse into how efficient your operations are.

You might have heard the term ‘profit and loss statement’, and an income statement is essentially the same thing. So, let’s take a look at what an income statement is, all of the components you might find in there, and how to understand them.

What is an income statement?

An income statement is a key financial analysis tool that shows your profit or loss over a specified period of time. Basically, it’s a complete view of your income and expenses, broken up into sections that are easy to understand.

Financial statements can be produced for any time period, and it’s quite common for businesses to produce and analyse them each month. Along with your balance sheet and cash flow statement, it gives you an easy snapshot of your profit and loss for any given period.

Income statements are also used by accountants and financial analysts to project future revenue and expenses. So, it’s not uncommon to see an income statement with past, present and future years listed as analysts try to forecast the future profitability of a company.

What are the main uses of an income statement?

Perhaps the main use of an income statement is to give details of your company’s profitability to shareholders or investors. It’s also an important factor should you ever want to sell your business. This is because it gives a really clear picture of your profitability.

You can also prepare income statements for different departments and segments of your business, although this requires a lot of income and expense splitting in your accounting. Still, it’s a great way to see which parts of your business are more profitable than others.

Another reason to maintain an income statement is to find ways to grow your business further. Do you need to increase your sales, or can you attain better profitability by reducing expenses?

Income statement example

Below we have an income statement example that reflects three historical financial years.

Income Statement 2019 2020 2021
Revenue 247,651 252,874 289,541
Cost of Goods Sold 85,067 88,764 92,823
Gross Profit 162,584 164,110 196,718
Expenses      
Marketing/Advertising 32,681 35,742 40,254
General/Administrative 45,846 47,521 56,327
Depreciation Costs 5,410 5,746 5,842
Other Expenses 2,847 1,600 2,957
Total Expenses 86,784 90,609 105,380
Operating Income 75,800 73,501 91,338
Interest Expenses 3,174 2,867 2,641
Taxable Income 72,626 70,634 88,697
Tax Payable 18,157 17,659 22,174
Net Income 54,470 52,976 66,253

As you can see from the example above, you get a clear picture of income and expenses, and how each figure has changed over the previous three years. It also shows that simply increasing your revenue and gross profit doesn’t necessarily lead to business growth.

In this example, between 2019 and 2020, the company increased their gross profit by $1,526. However, their expenses increased by $3,825, leaving them with a lower net income for 2020. Despite this, they managed to increase their net income by $13,277 the following year in 2021, which would be pleasing to all stakeholders. It may even show that some of 2020’s additional expenses had a positive long-term effect on profitability.

Income statement components

Income statements may look different for every business, mainly because expense types and income will vary. However, these are some of the key financial terms you will find in most income statements. While income statements can be prepared at any time, for any time period, we’ll be discussing these components as though we’re preparing an annual income statement.

1. Sales Revenue

This represents your total sales revenue for the year. This may vary depending on whether you do cash or accrual accounting, but in general terms, the first item on every income statement is your total income for the year.

2. Cost of goods sold

The cost of goods sold (COGS) is immediately deducted from your sales revenue on an income statement. It includes all the costs associated with making the goods that you sell. So, we’re talking about materials. For a restaurant, it would include all the ingredients and packaging. Or, for a retail store, it’s the cost of purchasing wholesale products that you sell.

Of course, you have other expenses involved in running your business, but COGS is only concerned with the products you sell. The other expenses come a bit later on.

3. Gross profit

The gross profit is essentially your sales revenue minus your cost of goods sold. It doesn’t take into account all of your additional expenses or overheads, so further down the income statement, you’ll be able to get an idea of how efficient your business is.

4. Expenses

This section groups together all of your operating costs aside from the actual cost of your goods. So, this includes all of your overheads to keep your business running from day to day.

5. Marketing and advertising expenses

Now we start getting into the expenses section. Most businesses have some form of marketing, advertising or promotion costs. This can include online advertising, production of brochures, radio advertising and all costs associated with promoting your business.

6. General and administrative costs

Some businesses break down their general and administrative costs into separate lines on an income statement, because it includes most of your other overheads. Examples are rent, wages, superannuation, insurance, office supplies and vehicle costs. So, this section may look quite different between businesses.

7. Depreciation expenses

Depreciation costs are less of a physical expense and more of an accounting item. It essentially refers to a decrease in the value of plant and equipment. For example, an account may create a deduction for how much a company vehicle has depreciated over the previous 12 months.

8. Other expenses

Other expenses can reflect anything else that doesn’t have its own category. Not all businesses will have ‘other expenses’ because most expenses on a balance sheet or income statement usually fit into one of the main categories.

9. Total expenses

Once all of your expenses are listed, your income statement shows a line item for all of your expenses.

10. Operating income

Not all Australian businesses include operating income on an income statement, however, it’s not a bad idea. This is where you can get some information about your efficiency because operating income is your gross profit minus your internal costs (the expenses listed above). Essentially, it shows your income after deducting all of the expenses you can control. It doesn’t take into account interest on loans or taxes, because you don’t have a lot of control over these.

11. Interest expenses

Interest expenses are related to any interest you pay on loans or leases.

12. Taxable income

Taxable income is also sometimes called ‘income before taxes’, however, most Australian businesses use the term ‘taxable income’. This is the income left over after deducting all of your expenses, including the cost of goods sold and total other expenses. It’s the amount on which the ATO calculates your tax payable. It shows how profitable your business is before tax.

13. Income taxes

This refers to the taxes you’re required to pay on your taxable income.

14. Net income

Finally, we have your net income. This is your total sales revenue, minus the cost of goods sold, operating expenses, interest and taxes. This shows the total income you earn after every single expense is taken into account.

How to read an income statement

Most income statements are pretty easy to understand, however, you need to know what you’re looking at. One thing to keep in mind is that an income statement is often broken into sections, with a lot of subtotals. In the components we listed above, gross profit, total expenses, operating income, taxable income and net income are all subtotals. So, when you do calculations, it’s important to recognise this fact so you don’t get confused.

Importantly, you need to know what each subtotal is telling you. For example, you can find opportunities to decrease your costs by looking at where your major expenses are. Is there a chance you can find different suppliers and decrease your costs of goods sold? Or are there possibilities of lowering your general and administrative costs?

As we mentioned, all income statements look slightly different because it depends on how you do your accounting. For example, you might simply include your cost of goods sold in your expenses section, and group all of your expenses together. This is a simpler way to do it but may not give you as much insight into your operating costs.

Hopefully, this gives you a clear picture of what an income statement is, and how you can use one in your business. Ultimately, it’s all about understanding your financial situation and being able to make smarter choices moving forward.

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