Why an Income Statement is Vital..... #34
- Adrian Dionisio - business737 owner
- Sep 7, 2021
- 5 min read
Updated: Apr 30, 2024
The world of finance tends to have a plethora of names for the same thing. This is the reason why accounting confuses so many people. As you read this article you will come across terms that are known by a variety of different names , all mean exactly the same thing. It can be confusing, but don't be worried.
An Income Statement has many other names. It is also known as a;
Profit and loss statement
Statement of operation
Statement of financial result
Statement of financial income
Earnings statement.
The Importance of an Income Statement
Businesses should consistently prepare an Income Statement in order to determine whether they are making a profit or loss and why.
This financial statement is the scoreboard for your business. It provides the vital statistics that reveal how your business is functioning.
The numbers on the Income Statement (also called Profit and Loss Statement) show the results of all your work, endeavour, time and effort.
The Income Statement highlights the financial health of your business and reveals the ability of a business to generate a profit. It is an absolute must.
Personally, for my businesses, I formulate one at the end of every month, quarter and year. It is the best way to keep track of the things that matter most.
What exactly does an Income (P&L) Statement Show?
It indicates all of the following;
Revenue
Revenue is also know as Income / (total or net) sales / gross revenue / turnover.
Many different name all for the same thing; all the money that your business has generated over the specified time period of the statement.
Subtract the total amount of returns and allowances from the company’s total sales to get this figure.
Expenses
Expenses are also know as costs or expenditure. All the money that you have spent with your business activities.
Expenses are generally divided into 2 different costs (fixed and variable)
Fixed Costs also know as Indirect Costs or Overhead Costs or Operating Expenses.
These do not change over the short-term, even if a business experiences changes in its sales volume or other activity levels.
They typically included rent, insurance, interest payments, overhead costs, depreciation, amortisation, salaries, utilities, taxes and so forth.
Variable Costs also known as Cost of Goods Sold (COGS) or Cost of Sales.
These are costs associated directly with making (or acquiring) the product.
These vary with changes in the activity level of a business. They typically include materials, products, packaging, the wholesale price of goods that are resold and all costs directly related to these goods.
Gross Profit
Gross Profit is also known as Gross Income or Sales Profit
Gross Profit = Revenue – Cost of Goods Sold (COGS)
This shows how efficiently a business is converting raw materials or stock into
a finished product.
Later you will read how this figure is used in calculating the extremely important Gross Profit Ratio. It's important to reiterate that COGS doesn’t include fixed costs (ie. expenses involved with the general upkeep of the business).
Operating Profit
Operating Profit is also know as earnings before interest and tax (EBIT).
A company's operating profit is its total earnings from its core business functions for a given period, excluding the deduction of interest and taxes.
Personally, I view interest and tax as expenses like all the others, so for my accounts I add the under operating expenses. Each to their own.
Net Profit
Net Profit is also known as Net Income
Net Profit = Revenue - Expenses ( fixed + variable)
This total represents the final measure of profitability for a company. It is the money that goes into your pocket. This figure may be a negative value, in which case the business is operating at a Loss. Red flag time.
This figure clearly shows whether the business is generating enough profit from its sales and whether operating costs and overhead costs are being contained.
Income Statement Examples
It is easy and straightforward to put together an Income Statement. Look at the examples below you will see each have slightly different entries, but all include the end totals which are crucial to monitor the financial health of a business.
Remember, the world of accounting has many different names that all mean exactly the same thing. Take a look at examples below to familiarise yourself with the income statement. You will soon see it is all fairly straightforward.
Your income statement will help with you classify and familiarise yourself with revenues and expenses. It is the best indicator of profitability for a business. It shows how efficiently your business is able to translate expenses into revenues.
It can help you determine if your business has the ability to generate earnings in the long term and can help you make important business decisions, like whether to invest in new, expensive equipment or whether to wait until your company is in a better financial position.
Assist in better decision making - Reading the income statement enables the business owners to be aware of the current financial footing of the company. With the accurate figures presented on the income statement, business owners can make swift and wise decisions about the company's expenditure.
Track the company's profitability - With an income statement, it provided the business owner, the shareholders, and stakeholders the knowledge of the company's financial standing.
Essential report for compliance - Operating your business in a country means companies will have to bear the various forms of business taxes, following the tax regulations of that country. Paying business taxes is mandatory by law. To calculate your tax liability, the income statement, and other financial statements (balance sheet and cash flow statement) will help a lot in providing the necessary financial data you will need.
Crucial Financial Ratios from an Income Statement
Gross Profit Ratio
The Gross Profit Ratio is also known as Gross Margin ratio or simply Gross Margin.
(gross profit ÷ revenue) x 100% = Gross Profit Ratio %
This is the percentage of revenue you retain after accounting for costs of
goods sold.
For every £ your business earns ( sells or every £ of income) , there is 73p (73%) in gross profit.
This is the most used key performance indicator for a business owner to determine if they are charging enough for their product. This is used as a benchmark to compare the the gross profit ratio against other businesses in the same industry.
A business owner can use this ratio to see how their gross profit ratio is compared to other businesses doing the same activity. It is a great comparison tool and you can use benchmark reports to compare against other businesses in the same industry
Net Profit Ratio
Also known as Profit Margin or Profit Margin Ratio or Return on Sales (ROS)
(Net profit ÷ Revenue) x 100% = Net Profit Ratio %
The net profit margin, or simply net margin, measures how much profit is generated as a percentage of revenue. It is the ratio of net profits to revenues for a business.
The net profit margin illustrates how much of each dollar in revenue collected by a company translates into profit.
Whether or not the net profit ratio is satisfactory can be determined by comparing the net profit ratios of other businesses in the same industry. You can use benchmark reports for this.
The net profit ratio tells you that for every £ earned ( every £ of sales or every £ of income), there is 51 p (51%) that goes to net profit, in other words that is money in your pocket after everything has been paid off.
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