When you say you’re in business, one of the first questions people will ask is whether or not you’re profitable. So how can you tell?
Profit performance is presented in a report called the income statement.
The income statement summarizes sales revenue and expenses for a period of time – usually a year. It’s created to be read in a step-down manner.
Income Statement
| Sales Revenue | $54,000 |
| Cost of Goods Sold | ($32,000) |
| Gross Profit | $22,000 |
| Selling, General, & Administrative Expenses | ($11,000) |
| Depreciation Expense | ($1,000) |
| Earnings Before Interest & Income Tax | $10,000 |
| Interest Expense | ($1,000) |
| Earnings Before Income Tax | $9,000 |
| Income Tax Expense | ($2,000) |
| Net Income | $7,000 |
The top line shows the total proceeds from sales to customers. From there, each step down is a deduction of expenses. The first step deducts the cost of goods sold from the sales revenue. This gives us the gross profit.
Next, the broad category of operating expenses called selling, general, and administrative expenses, along with a depreciation expense, are both deducted from gross profit. This gives us earnings before interest and income tax, which is also known as operating earnings.
Then the interest expense is deducted from this number, giving us earnings before income tax. And the last step is to deduct the income tax expense, giving us the net income number on the very bottom of the income statement.
The sales revenue and various expenses in an income statement follow generally accepted conventions. Here’s a brief summary of each.
Sales Revenue
This is the total amount received from the sale of products or services during the period. It’s a net figure, meaning that discounts, returns, and other deductions from original prices are subtracted to determine the true sales revenue amount. Sales taxes are not included.
Cost of Goods Sold (COGS)
This is the total cost of products sold to customers during the period. Any goods that were stolen or are missing, as well as write-downs due to damage, are considered inventory shrinkage. The cost of this shrinkage may be included in the COGS expense, or put in another expense account.
Selling, General, and Administrative Expenses (Operating Expenses)
This includes every expense other than COGS, depreciation, interest, and income tax. However, some companies report advertising and marketing costs separately from administrative and general costs. Others also report research and development costs separately.
The amount of detail for expenses in an income statement is somewhat flexible. Financial reporting standards are not as strict on this point.
Depreciation Expense
This is the portion of original costs of long-term assets that is recorded to expense in one period. These assets may include buildings, machinery, equipment, and vehicles.
In essence, it’s a charge for using the assets for the period. But since this expense isn’t an actual cash outlay, it’s a unique expense compared to the other operating expenses.
Interest Expense
This is the amount of interest paid on debt for the period. Other financing charges – such as loan origination fees – may also be included.
Income Tax Expense
This is the total amount due to both the federal and state government on the amount of taxable income that the business earned during the period.
The income tax expense doesn’t include unemployment taxes or Social Security taxes on the company’s payroll. These non-income taxes are included in operating expenses.
For more detail on the income statement, check out How to Read a Financial Report by John Tracy.
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