Every entrepreneur who makes it past the “business plan on a napkin” stage will have some level of familiarity with the income statement. It is, after all, the fundamental report for understanding financial performance over a period of time.
But in my conversations with business owners, I’m surprised how few report spending much time with the income statement as a go-to source for real performance analysis. For many, it’s a major missed chance to identify business improvement opportunities.
The income statement doesn’t have to be intimidating, though. And, you don’t need to have a formal accounting background to put it to work for you. Acquiring just a basic understanding of trend analysis, variance reporting, and key financial ratios can immediately turn the income statement into a powerful source of business intelligence.
How I learned to stop worrying and love the income statement
Generally, if you ask an accountant which financial report is the most important to understand, they’ll tell you it’s the income statement—followed by the balance sheet and cash flow report, of course. But the income statement is usually the first one they’ll mention.
What critical data does an income statement provide? Let’s ask wiki.answers.com:
“An income statement directly shows whether the business has a net profit or a net loss. In sum, it takes all the revenues and subtracts all the expenses.”
Yep. That pretty much nails the basics!
But if you’re looking for a bit more complete definition of the income statement, that’s more accessible than many of the more impenetrable versions floating around the internet, consider this one from Inc.com:
“An income statement presents the results of a company’s operations for a given period—a quarter, a year, etc. The income statement presents a summary of the revenues, gains, expenses, losses, and net income or net loss of an entity for the period. This statement is similar to a moving picture of the entity’s operations during the time period specified. Along with the balance sheet, the statement of cash flows, and the statement of changes in owners’ equity, the income statement is one of the primary means of financial reporting. The key item listed on the income statement is the net income or loss. A company’s net income for an accounting period is measured as follows: Net income = Revenues - Expenses + Gains - Losses.”
While definition terminology can vary (for instance, some people refer to “revenue,” while others others will call it “sales” or “operating income”), the fundamentals are the same. At its simplest: An income statement tells you how much net income has been made in a period of time by subtracting money in from money out.
There are many compelling business reasons to make sure you’re able to produce an accurate income statement—beyond just understanding your net income or net loss. You’ll need an income statement for:
- loan qualification
- investor contributions
- tax preparation
Additionally, income statements provide a window into your company’s financial health and can be used to guide business decisions. Since banks, investors, and tax preparers already know what to do with your income statement—let’s focus in on what you can do with it.
Basic income statements analysis
How do you tell how things are going with your company’s performance? Gut feel? No checks bouncing? Bank account balance? Income statements provide a more complete, data-driven answer. In fact, that’s one of the main reasons you have them.
Click here to expand sample income statement
Click here to contract sample income statement
Again, the most important thing an income statement tells you is how much income has been made during a particular period of time. In the example above, the sample company has had a positive month with net income of $7,513.05.
But an income statement does much more than identify net income. It also provides a digestible way to understand the basic nature of the various revenues and expenses. In every income statement, dozens, hundreds, thousands, or even more individual transactions have been boiled down into a number of specific categories.
Basic metrics like total income, total cost of goods, gross profit, total expenses, total other income and expenses, and net income provide a common language to communicate performance. With this language, we can consult a financial statement to answer fundamental performance questions:
- How much did we sell? We had combined labor and product net sales of $33,772.36.
- What were the costs on the items we sold? Our cost of goods sold was $14,500.
- What were our overhead costs? We had total operating expenses of $7,763.74.
- How much did we make before Uncle Sam took his? Our net income before taxes was $10,642.28.
Income statements and financial ratios
Everything we’ve discussed so far is pretty straightforward. Common knowledge, you might say. As complicated as we’ve gotten is some addition and subtraction to come up with our overall net income. This is a useful, but limited level of interpretation.
Financial ratios let us dive much deeper. Financial ratios provide a way to make sense of income statement data to illuminate which factors are driving performance. Ratios are useful because they turn multiple numbers into a single numeric performance indicator.
Again, let’s ground ourselves with a quick definition from Wikipedia.org:
“A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization”
As noted, you have lots of choices when it comes to financial ratios. Ratios can help measure profitability, productivity, and variety of other financial indicators.
To get a feel for the power of financial ratios, let’s take a look at what’s known as a “common size analysis.” A common size analysis translates each line item appearing within a financial statement into a % of net sales. Essentially, every line in the income statement becomes its own financial ratio, with net sales acting as the common denominator. What’s the point? There’s two actually.
Click here to expand sample common size analysis
Click here to contract sample common size analysis
The first big benefit of a common size analysis, is that it focuses attention on the amount of influence each line item relatively exercises.
Second, a common size analysis offers the ability to benchmark performance against other companies—even if the two companies are different sizes. For instance, if another company is dealing with much larger revenues and expenses than your business—you might have a hard time making sense of whether you are relatively paying more or less taxes, just by looking at the raw numbers. Your common size analysis provides a solution. You can easily determine the proportional amount you pay on taxes relative to net sales (9.27%) and compare that to industry standards or another company data—despite differences in size.
Income statements and trend analysis
Comparison is at the heart of financial analysis. One of the most important comparisons to make is to analyze performance in relation to past results. It enables us to determine if performance in each recorded financial dimension is better or worse. When we know that, we’re able to determine if our company needs “more of the same” or “to make some changes.”
Click here to expand sample trend analysis income statement
Click here to contract sample trend analysis income statement
Take a look at the numbers above. Its great to know that our February net income was $7,513.05. But it’s especially useful to identify that our current net income represents a 50.05% improvement versus the previous year’s corresponding month.
What’s the reason for the improved profitability? Walking through our sample income statement analysis exercise with an eye toward what’s changed in business conditions reveals some answers behind the data.
- Sales are up. We’ve seen a sales revenue increase of 19%. I guess the new sales guy is working out!
- Labor sales are really doing great. They’re up 280.77%. If we can apply some of our successful promotional tactics in this area to our product sales, where we’ve only seen a 8.44% increase, we might be able to really drive a net sales increase.
- Our grip on product costs has gotten tighter. We were able to decrease the cost of goods sold even though we increased our product sales revenue. Taking the time to source a new supplier paid off!
Income statements and budget variance reporting
Income statements not only provide an opportunity to evaluate financial performance, but a way to evaluate financial performance relative to expectations. Budgetary expectations, consequently, are very often collated into the display of income statement results.
Click here to expand sample budget variance statement
Click here to contract sample budget variance statement
Taking a quick look at the net income budget variance tells us pretty quickly we’ve exceeded our own expectations in this income statement period. Our net income is up fully 39.13%. But why? How’d we do it?
- It wasn’t because we limited operating expenses. Our operating expenses were pretty much dead-on what we expected (-0.46%).
- Taxes were up. But that’s an expense. That doesn’t help us generate more income—and is only okay if we proportionally increased revenues.
- Sales outperformed expectations. Good news: we did increase our revenues! (Our tax jump is ok because it was just a result of more sales.) Both product sales (+18.16%) and labor sales (+41.07%) outpaced our expectations—and, again, we’re happy with our new sales guy, Doug. If Doug keeps this up, we may need to adjust our planning model.
In this case, the numbers represented positive gains versus the forecasted figures. But monitoring income statements in relation to budgeted numbers likely won’t always display such positive returns. When it doesn’t, it provides a place to start the detective work.
Our simplified model boils revenues and expenses down to a few account categories. In the real world, you’ll likely break things down even further. The greater the precision, the better you’ll be able to target the area that needs work to meet expectations. Depending on the size of your business, that might mean setting up 10, 20, or 100 expense or revenue categories. The individual answer you come to regarding the extent of your breakdowns will be a result of where you set the trade-off between complexity and control—and how deep into the income statement rabbit hole you want to dive.
Income statements provide a wealth of opportunities to gain insight on your company’s financial performance—in fact, far more opportunities than I could realistically hope to catalog here. If you’re looking to expand your understanding of some of the topics covered in this article and dig deeper, check out the following sources: