Income statement breakdown

Business Finances can be scary…

I'm going to break down the most important financial report inside a business, The Income Statement, so a second-grader could understand it:

The Income Statement tells you whether or not you’ve made a profit over X period of time. It also shows why or why not.

The Income Statement Formula:
Revenue - Expenses = Profit

Reports are typically viewed on a monthly, quarterly, and annual basis.
(Yes, it can really be that simple)

Expenses are then broken down into 2 broad categories:

1. Cost of Goods Sold (COGS): these are costs related directly to the sale. You can think about it like costs related to producing the revenue.

2. Operating expenses: These are the overhead costs to run the business, but are not directly related to revenue

Why does the income statement matter?

The income statement will help you tweak high-leverage variables

• Identify how much revenue/profit you bring in

• Identify the leading causes of your situation

• Understand your products margins and where you can cut costs or raise prices

Here's an example of a simple income statement:

Revenue (total sales during the period of time)

- Cost of goods sold (cost to produce the sales)

= Gross Profit (profit from selling the product/service)

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- Operating Expenses (overhead costs not directly related to the sales)

= Operating Income (profits from operating the business)

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- Non-operating expenses (one-time or nonoperating expenses)

= Net Income (total profit/loss)

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EBITDA = Earnings before interest, taxes, depreciation, and amortization

EBIT = Earning before interest and taxes

Examining what each line means on the income statement:

Companies usually start off with very simple income statements. If you're a bootstrapped start-up or a solopreneur, you should simply be focused on the bottom line. How much money did you spend vs. how much money did you make?

As companies continue to grow, more details are needed on the income statement.

First, is the Cost of Goods Sold, or "COGS" for short:

This is any expense directly related to EARNING the Revenue.

1. For product-based businesses, this would be the cost of product (either purchased when needed post-sale or taken from existing inventory)

2. For service-based businesses, this would be the employee or labor cost to fulfill on the sale (hours directly booked to a project)

Tracking Cost of Goods Sold allows you to see a Gross Profit subtotal.

By examining your gross profit you can then track and measure your cost that's directly related to the product or service! This is relevant so that you can understand your margins and see if you're getting any benefits (or running into issues) as you scale.

When you gain benefits from your gross profit margins as you scale this is usually referred to as economies of scale. For example, if you buy 10,000 units of product in bulk, you may be able to get them for cheaper.

When you run into issues from your gross profit margins as you begin to scale this is usually referred to as a bottleneck. For example, if you run a service-based business but run out of labor to fulfill on the sales, you may need to start paying people more money to provide the service required (thus losing some margin).

Next up, we have the General & Administrative Expenses:

This is anything not-related directly to the cost of the sale (revenue) but is simply the cost of operating the company.

It can be broken down into many additional categories or line items that suit the particular business in question. It's best to work with an accountant or business owner to identify what these line items will be.

You may want to drill down into more granular details of categories you’re interested in, such as:

• Sales, Marketing, Advertising

• Human Resources

• Rent, Maintenance, Utilities

• Software and subscriptions

Many of these categories are requested by CPA’s filing taxes so they can ensure they are reporting accurately and optimizing write-offs, and many are simply at the discretion of the business based on what they find important to track.

The best general advice is to try to stick to whatever you decide to set up. If you aren't consistent it might make comparing previous financial statements hard to do, which makes actionable advice almost hard to follow.

You now understand the parts of an income statement, what's next?

Typically speaking, most businesses want to analyze their health in terms of 3 angles of time. How are they doing compared to the past, how are they doing compared to their forecasts, and how are they doing today here and now?

Some important questions to ask when analyzing an income statement are:

• How much revenue did we bring in and is it growing?

  • What direction is it trending?

  • What is causing the trend?

• What is happening with our gross margins?

  • Are we more or less profitable as we scale?

• Did our operating expenses go up or down compared to sales?

  • If revenue is decreasing are our operating expenses also decreasing to match this?

• How are our costs compared to last year?

  • Find places that aren't directly generating value and cut them

  • How are we doing compared to what we budgeted/forecasted?

• Lastly, what is the net profit? The ultimate goal of the business.

  • Is this number increasing at a healthy rate?

  • What is the profit margin? (net profit/revenue) - this will show if you can sustain growth.

Recap

The income statement is one of the most important financial statements to track inside a business. It can give an incredible overview of how a business is doing over a given period of time.

We discussed how the income statement formula (Revenue - Expenses = Profit) is broken down and what questions to ask to ensure you're analyzing the business from all angles.

Now you no longer need to be scared to dive into the weeds of a business's financials. So next time you're evaluating a business or looking at your own, you can provide insight or take some actionable steps toward improving the business.

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