The Income Statement is also called the Profit & Loss (P&L) Statement, reminding us that losses
are part of the equation. In order to be profitable - simply put - you must stay out of the red and learn to identify trends that move your dial in the right direction. Your Income Statement provides a fantastic starting point for financial analysis.
Remind people that profit is the difference between revenue and expense. This makes you look smart. -Scott Adams
Why do we start businesses?
- to sell a product or service
- to invest
- to separate property from personal ownership
- to create a job for oneself
- to share intellectual property
- to fund hobbies
- to spend time and money
- to protect property
- to establish a mechanism to share an estate and
- the list goes on....
Much of the existing confusion in terms of profits rises from the
two accepted formats of the Income Statement: single-step and multi-step
. Single-step is simpler and does not give information about gross margin or pretax income. Multi-step includes itemized sources of revenue and expenditures.
Single-Step Income Statement
In the single-step format,
Net Income is derived from this equation:
- NET INCOME = (REVENUE + GAINS) - (EXPENSES + LOSSES)
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Single-Step Income Statement
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| Sales |
| Materials and Production |
| Marketing and Administrative |
| Research and Development Expenses (R&D) |
| Other Income & Expenses |
| Pretax Income |
| Taxes |
| Net Income |
Multi-Step Income Statement
In the multi-step format, line-item information provides a better understanding of exactly where your money is coming and going. This version considers both revenues and expenses that directly relate to production and those that don’t.
- GROSS PROFIT = SALES REVENUE - COST OF GOODS SOLD
Another interesting concept is
operating income, which results after deducting most costs– direct or not -- from the sales or income of your organization.
- OPERATING INCOME = GROSS PROFIT - OPERATING EXPENSES
Finally,
net income includes tax payments, and is the same in both formats.
- NET INCOME = OPERATING INCOME + (NON OPERATING INCOME -EXPENSES)
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Multi-Step Format
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Sales
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Cost of Sales
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Gross Profit (Gross Margin)*
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Selling, General and Administrative Expenses (SG&A)
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Operating Profit (Operating Income)*
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Other Income & Expenses
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Pretax Income
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Taxes
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Net Income (after tax)*
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The bottom line
Many small businesses would rather face an angry barbarian horde than tackle their cash flow statement or price a new product. -Nicole Dende, How to Be a Finance Rockstar
The Income Statement formula provides important information about profits.
Gross profit (also called
gross margin) is the result of measuring profits based on direct costs.
In the cases of service industries, these costs are mostly time-related. If you are self-employed, pay yourself a rate for performing tasks – direct costs or cost of sales,
plus a rate for managing the organization.
From an income perspective, the
sales line typically indicates what an organization intends to sell. (This creates an image of who the clients are; an organization needs to fulfill these conceptions in order to generate Income.) Most likely, sales are the result of a combination of products
and services, and not just one or the other. Let’s call all products and services offered by an organization 'products,' this is also a widely accepted practice by authors, consultants, and coaches.
Typically, non-operational income includes interest from bank accounts; however, there are many hidden sources of non-operating Income. Some by-products that can be considered waste may have a market value:
- paper can be sold and recycled
- databases can be rented
- natural gas can be injected back into a subterranean field
- solar power can feed electric networks
These non-operating sales can generate confusion about the mission of the company, but there are many cases where this perspective has allowed companies to turn themselves around after encountering difficulties, and have even shifted completely to a new offering, reshaping the former strategy. This is called
pivoting.
Pivoting in action: A young entrepreneur returned to a family-owned wood supplier business and found an interesting market in wood flour, a by-product. What began as an exercise to reduce costs of disposing by-products, turned into a successful source of income. Five years later, the company was able to export wood flour from itself and its local competitors to Asia. The company shifted its mission from providing timber for furniture manufacturing to providing wood flour globally.
Another pivoting example: A consulting company provides rental space to other companies. This allowed it to grow faster and to be more flexible in its cash planning. Both examples show how we can utilize an Income Statement to make strategic decisions, not to watch results. You can do this if you understand all the details of your income.
Using all the tools at your disposal - including the use of data and financials to inform your operations will help you keep yourself and your small business out of the red.
