When it comes to determining the financial health of a business, a question that comes up often is what an income statement is.
An income statement - also known as profit and loss statement - is one of the key financial statements analyzed, looking at a company's income in a given period. It helps you understand a company’s income versus its expenses to evaluate business performance.
| What goes in an income statement? | Definition¹ |
|---|---|
| Revenue | All of the money your business earns from selling its goods and services |
| Cost of Goods Sold | The true cost to produce and sell goods or services, including raw material and labor needed. |
| Operating Expenses | All expenses incurred to keep the business running as normal, such as rent. |
| Depreciation | Expenses that incur over time, such as the declining value of equipment and assets. |
| Gross Profit | The total profit your business earns, after subtracting the cost of goods. |
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This article will look at how to prepare an income statement in 9 easy steps.
How to prepare an income statement in 9 steps
1. Start with revenue
The first step is to add revenue figures for your reporting period.
Revenue can include sales from products and/or services sold.
It can also include any revenue earned through interest, sold assets, and other income streams your business might have.
2. Subtract returns, discounts, and other allowances
Once all the revenue is added up, you’ll subtract returns, discounts, and other allowances to identify your net sales figure.
Net sales is the total of sales without deducting for operational expenses. It helps you better understand how much money the company is truly earning.
3. Include Cost of Goods
The next step in preparing an income statement is to include the Cost of Goods figures.
The cost of Goods includes both the raw material and labor needed to create and bring your product to market.
Cost of Goods can also include overhead directly related to production, such as factory expenses incurred.²
4. Calculate Gross Profit
Once you’ve included your total revenue and figures for the Cost of Goods Sold, you’ll then have the calculation for gross profit.
Gross profit shows how much money your business has made after accounting for the costs to create the product itself.
It’s a key measure to understand business health and the overall profitability of the business.
5. Add figures for operating expense
Operating expenses are defined as any costs incurred to keep your business running normally.
Most businesses tend to have similar types of operating expenses such as marketing and advertising, wages, and rent. However, some businesses will have more operating expenses than others or have different ones.
For example, international businesses might have more operating expenses due to managing multiple locations and payroll compared to domestic businesses.
For this step, take some time to fully identify all operating expenses your business incurs to ensure you’re getting the full picture.
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6. Calculate operating profit
After entering all your operating expenses, you will have to calculate operating profit.
Operating profit refers to your business’ profits after deducting operating expenses. It shows how much money your business has to spend after paying its expenses but before interest or tax.
This measure is crucial to identify how high your profit margins are, and it’s a key measure of financial performance.
7. Add other income
If your business has any sources of income that are not generated or related to its core services or products, it is included as other income.
This can include money earned from interest or from selling assets.³
8. Subtract taxes
The next step for preparing your income statement is to subtract tax expenses from profit (before tax).
Tax expenses can vary based on what country your business operates in and if you have multiple international locations.
It can be beneficial to get familiar with international taxes and business obligations, including treaties and other measures.
This is the last deduction you’ll need to make from your profits to understand profit and loss for your business.
9. Calculate net profit
Now that all the information is included for revenue, cost of goods sold, operating expense, and taxes, you should have a figure that shows your company’s net profit.
This is how much your business earns after deducting expenses, taxes, and interest. It shows how well your business is performing financially and whether it can retain profits after deductions.
It’s a key metric used to determine financial health and forecast how businesses might perform in the future.
Income statement example
To help with the process, here is an example of an income statement. The first example below is a simple income statement to help you identify how profitable your business is versus how much it is spending.
If you’d like a more comprehensive overview of a business, here is an example of an income statement that goes deeper.
In the comprehensive income statement example, the income statement is broken down into three areas: Revenue, Cost of Goods Sold, and Operating Expense.
Always remember that income statements are an important part of financial analysis, but you should not evaluate them in isolation.
To fully determine the financial health of a business and its profitability, it is crucial to look at other financial statements, such as cash flow and balance sheet for a more well-rounded analysis of how your business is performing.
Income statement vs. Balance sheet
When we look at financial statements as a whole, income statements and balance sheets complement one another.
An income statement looks at a company’s profit and loss, and is used to understand how profitable a business is after it accounts for its expenses.
However, a balance sheet looks at how much a business is earning versus its liabilities to understand its total value of the company.⁴
One of the key differences between income statement vs balance sheet is timing.
- A balance sheet shows a snapshot of the company’s assets and liabilities at a specific moment in time.
- The income statement shows profit and loss over a specific reporting period, such as a year.
The second difference is what the income statement includes versus the balance sheet.
- The income statement includes all of the money earned and spent by a business.
- However, a balance sheet only looks at assets, liabilities, and equity. It does not look at expenses and income, but simply what the company owns versus what it owes.
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| *💡 Did you know? |
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| Wise did some research, comparing their business prices to PayPal’s. The research was carried out between 6 Janaury 2021 and 14 January 2021. |
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Sources:
- Score - Everything You Need to Know About the Income Statement
- Investopedia - Does gross profit include labor and overhead?
- Corporate Finance Institute - Income Statement Definition: Uses & Examples
- Small Business - Difference Between Income Statement & Balance Sheets
All sources checked 11 November 2021
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