Introduction to the Income Statement

Computer screen showing revenue, which is part of income statements

Income Statement Basics

Understanding income statements is crucial if you want to know how businesses operate. Whether you are running a small company in Orange County or are just interested in accounting, learning income statement basics is time well spent. So, without further ado,  My OC Bookkeeper presents you with our introduction to income statements 2018. (Also, remember an income statement is the same thing as a profit and loss statement. One name is never enough in accounting…)

The income statement, balance sheet and statement of cash flows combine to create a business’s financial statements. (Check out our introduction to the balance sheet here.) Each component of the financial statements provides a unique kind of information about a business: the balance sheet offers a snapshot of the financial condition at a given moment in time, the income statement tracks the revenues and expenses through time, and the statement of cash flows tells you how close you are to running out of cash. These statements can be used to do everything from checking last month’s profits to building complex financial models and are included in annual reports or 10-Ks. (Check out the U.S. Securities and Exchange Commission website to see some sample public company 10-Ks.)

What Does an Income Statement Show Me?

The income statement uses flow variables. This means that it provides you with information regarding what happened over a period of time, for example throughout the first quarter. (Do you remember our introduction to the balance sheet? We learned there that unlike the income statement the balance sheet provides a snapshot of a company in time, for example on a given day.)

What does an income statement track through time? All of your revenues and all of your expenses. At the very top the statement is the amount of revenue that was earned throughout the period in question. It may just provide a single ‘revenue’ line item, or it could break up the revenues into types, for example sales revenue, marketing revenue, etc.

Now that you know how much you earned you need to know how much you spent. After the revenues the expenses are deducted. Expenses can be all kinds of things. Rent, marketing expense, gas expense, salaries, debt payments, you name it.

After we deduct the expenses we get to the most important thing of all: profits. This comes at the bottom of the income statement – hence the expression ‘the bottom line’.

So the income statement will not only tell you your profits, but also breakdown where they come from and what expenses had to be deducted to get there. This is key information for any small business owner. (Whether you are in Orange County or not.) If you want to succeed you must know where your money is coming from and where it it going.

Income Statement Vocabulary

A more advanced understanding of an income statement starts with vocabulary. We’ve put together some useful definitions below. Don’t worry if you haven’t encountered any of them. Some are reserved for more advanced financial statements. (Check back for some upcoming advanced financial statement training posts.)

Cost of Goods Sold (COGs)

This is a line item which can be deducted from total revenue create a new category: gross profit. COGs represents a grouping of all of the expenses directly related to the actual creation of a product. (As opposed to its sale, for example.) All of the costs of manufacturing your widgets and the materials you used in making them can be included in COGs.

Gross Profit

When you deduct cost of goods sold (COGs) from your total revenue to calculate your gross profit you are using ‘gross profit’ accounting . This can be useful when you want to know how much money your product has created after deducting the production expenses ONLY. To do this you just just add two new line items to the statement, i.e. COGS and gross profit. Then you just deduct all of the regular expenses to reach your bottom line.

Depreciation and Amortization

This is a line item on your income statement which deducts value from your assets based on an assumed depreciation / amortization schedule. That just means that the value of assets that you own, i.e. assets on your balance sheet, decrease over time. Factories, tractors, and wind mills all fall apart eventually. A business owner has to account for this loss in value and it is down by deducting it from the income statement. (This might sound a bit strange. Come back around for some advanced financial statement training if you find this provocative.)

What is the difference between depreciation and amortization? Depreciation is for tangible assets like buildings, and amortization is for intangible assets like contracts.

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Interest, taxes, depreciation, and amortization are usually some of the last things you deduct on the income statement. Before you do so, you may want to get a subtotal letting you know how the business is doing outside of these issues. That’s all EBITDA is. Simple.

EBIT

EBIT stands for earnings before interest and taxes. It’s basically the same thing as EBITDA but it represents your total profit after deducting depreciation and amortization but before deducting interest and taxes.

Gains & Losses

With gains and losses you are getting into some stranger territory but the concept remains quite easy. You get a gain when you sell an asset that is not your product for a gain relative to the price you paid for it. So if you sold an extra widget maker for $100 more than you paid for it you have a gain. If you sold it at a loss you have a loss.

More Learning

So there you have it. Income statements basics 2018. Be sure to also check out our introduction to the balance sheet and our upcoming introduction to the statement of cash flows. Also, check back soon for some advanced financial statement tutorials and feel free to to watch the intro to the income statement video below.

Are you a small business in the Orange County, CA area? If so, reach out to us at My OC Bookkeeper for some help with all things accounting and tax.

 

What is a Balance Sheet?

A traditional balancing machine symbolic of a discussion of balance sheets.

Balance Sheet Basics

 

It’s a beautiful day, the sun is shining (or not), and the time has come for My OC Bookkeeper to review some balance sheet basics for our dear readers. Understanding balance sheets is central to understanding the health and character of your business, and it doesn’t take a lot of work to develop a strong foundational understanding. So grab your cup of coffee, turn on some nice music, and let’s begin.

The balance sheet, income statement (also known as a profit and loss statement), and statement of cash flows combine to create a business’s financial statements. Each component of the financial statements provides a unique kind of information about a business: the balance sheet offers a snapshot of the financial condition at a given moment in time, the income statement tracks the revenues and expenses through time, and the statement of cash flows tells you how close you are to running out of cash. These statements can be used to do everything from checking last month’s profits to building complex financial models and are included in a business’s annual report or 10-K. (Check out the U.S. Securities and Exchange Commission website to see some sample public company 10-Ks.)

So What Does a Balance Sheet Tell Me?

As noted above, a balance sheet provides you with a snapshot of your business at a given moment in time. Everything your business owns, or owes, is included on the balance sheet as either an asset, a liability, or shareholder’s equity.

By looking at their balance sheet and comparing various pieces of information a small business owner can gain insights into the health of their business. Are my vendors paying off their debts quickly enough? Check the balance sheet. Do I have enough cash available to consider an expansion? Check the balance sheet. Are my assets worth more than my liabilities? Check the balance sheet. Can I afford to hire a new employee? You guessed it, check the balance sheet.

What Categories Are On A Balance Sheet?

One of the central roles of the balance sheet is organizational. By organizing a business’s assets, liabilities, and equity into easy to use categories it makes it easy to understand how the business is functioning and how all of its parts fit together. The first step is separating the assets, liabilities, and shareholders equity. The fundamental accounting equation tells us that assets = liabilities + shareholder’s equity so we use these as our three main categories. If you don’t understand this don’t worry, we will go into more detail in another post. For now just remember that the total value of a companies assets equals the combined value of its liabilities and equity, and that these are the three main categories used to organize a balance sheet.

Let’s break down a companies assets into some subcategories.

Assets

Assets are anything that a business owns that has value and represent our first category. They can include anything from a company car to a factory to a million widgets. Assets are broken down into current assets and long term assets, and then broken down again within those categories.

Current Assets, also known as short term assets, are assets that can be easily converted into cash within one year. Examples include inventory you expect to sell in the near future, cash, or accounts receivables.

Long Term Assets, also known as fixed assets, are assets of a more long term nature that you don’t expect to convert into cash. Examples include a factory, heavy machinery, and a company car.

By organizing all of your assets into categories such as these you can create a simple list of everything of value that your company owns and use this information to make decisions. Remember our discussion of an expansion? We could check our balance sheet and see how much cash we have available to do so. (To find the amount of cash we simply go to assets, then current assets, and then cash. Interested in furniture? We could go to assets, then long term assets, and then look for furniture.) But before making our final decision let’s check out the other half of the balance sheet: liabilities and shareholder’s equity.

Sample balance sheet for small business.

Liabilities and Shareholder’s Equity

This is where we put everything that isn’t an asset. For the time being, let’s focus on liabilities. Liabilities represent any debt or obligation that a business holds. Examples include accounts payable, loans, and deferred revenues. (Props if you know what deferred revenues are. If not, you can learn all about deferred revenues here.)

As was the case with assets, liabilities are first broken down into current and non-current (long term) liabilities and then broken down into subcategories. If they are due within a year, then they are current. If not, they are non-current.

So if we are still interested in a possible expansion, we could check how much cash we have on the assets side of the balance sheet, and then get an idea of how much we have to spend on debts on the liabilities side. By looking at all of our assets and all of our liabilities together we are starting to get a good idea as to the biology of our company.

There’s just one piece left: shareholder’s equity. Equity can be a bit more confusing than the other parts of the balance sheet, but is still pretty straightforward. Just remember that equity is the difference between assets and liabilities. (As per the fundamental accounting equation: assets = liabilities + equity.) So if you have more assets than liabilities, hooray, you will have positive equity.

Advanced Balance Sheet Training

Those are the basics. Let’s quickly summarize: a balance sheet is a snapshot of a company that enables you to examine all of its financial pieces in an organized manner. This information can be used to do all kinds of cool things, from the very basic to the very advanced.

If you are interested in some advanced balance sheet training you have come to the right place. We will be posting an advanced balance sheet tutorial in the near future, so stay tuned.

Are you a small business owner looking for some accounting and tax expertise? My OC Bookkeeper provides the best small business bookkeeping and tax assistance available in Orange County.

To learn more about balance sheets check out the cool video below.