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. For a more detailed explanation of COGS, check out our introduction to Cost of Goods Sold.
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 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 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.
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.