The income statement is a simple and straightforward report on a business' cash-generating ability. It's a scorecard on the financial performance of your business that reflects when sales are made and expenses are incurred. It draws information from the various financial models such as revenue, expenses, capital (in the form of depreciation) and cost of goods.
By combining these elements, the income statement illustrates just how much your company makes or loses during the year by subtracting cost of goods and expenses from revenue to arrive at a net result, which is either a profit or a loss. It differs from a cash flow statement because the income statement doesn't show when revenue is collected or when expenses are paid. It does, however, show the projected profitability of the business over the time frame covered by the plan. For a business plan, the income statement should be generated on a monthly basis during the first year, quarterly for the second and annually for the third.
Your income statement lists your financial projections in the following manner:
- Income includes all the income generated by the business.
- Cost of goods includes all the costs related to the sale of products in inventory.
- Gross profit margin is the difference between revenue and cost of goods. Gross profit margin can be expressed in dollars, as a percentage, or both. As a percentage, the GP margin is always stated as a percentage of revenue.
- Operating expenses include all overhead and labor expenses associated with the operations of the business.
- Total expenses are the sum of cost of goods and operating expenses.
- Net profit is the difference between gross profit margin and total expenses. The net income depicts the business' debt and capital capabilities.
- Depreciation reflects the decrease in value of capital assets used to generate income. It's also used as the basis for a tax deduction and an indicator of the flow of money into new capital.
- Earnings before interest and taxes shows the capacity of a business to repay its obligations.
- Interest includes all interest payable for debts, both short-term and long-term.
- Taxes includes all taxes on the business.
- Net profit after taxes shows the company's real bottom line.
Although the basics of an income statement are the same from business to business, there are notable differences between services, merchandisers, and manufacturers when it comes to the accounting of inventory.
For service businesses, inventory includes supplies or spare parts--nothing for manufacture or resale. Retailers and wholesalers, on the other hand, account for their resale inventory under cost of goods sold, also known as cost of sales. This refers to the total price paid for the products sold during the income statement's accounting period. Freight and delivery charges are customarily included in this figure. Accountants segregate costs of goods on an operating statement because it provides a measure of gross profit margin when compared with sales, an important yardstick for measuring the firm's profitability.
For a retailer or wholesaler, cost of goods sold is equal to total inventory at the beginning of the accounting period plus any merchandise purchased, including freight costs, minus the inventory present at the end of the accounting period. This is your total cost of goods sold.
Although manufacturers account for cost of goods sold in the same manner as merchandisers by reporting beginning and ending inventories, as well as any purchases made during the accounting period, their approaches are also different because they track inventory through three phases.
- Raw material is purchased to create a finished product.
- Work-in-progress is inventory that is partially assembled.
- Finished products are inventory fully assembled and available for sale.
Associated with this process are other costs, such as direct labor and factory overhead. To account for all these costs, manufacturers usually report them on a separate statement called the "cost of goods manufactured." This statement is formed by first listing the work-in-progress inventory at the beginning of the accounting period. The next listed are raw material and direct labor. The total cost of materials available for use includes inventory at the beginning of the accounting period plus new purchases and freight charges. Subtract the raw material inventory present at the end of the reporting period from the cost of material available for use to determine the cost of materials used. Add direct labor and manufacturing overhead to this amount. This results in your total manufacturing costs. Add the work-in-progress beginning inventory present at the end of the accounting period. This supplies you with the cost of goods manufactured.
In the income statement for manufacturers, cost of goods manufactured is added to the finished goods inventory at the beginning of the inventory, resulting in total cost of goods available for sale. The finished goods inventory present at the end of the reporting period is subtracted from this amount to produce the cost of goods sold.
When comparing several income statements over time, you can chart trends in your operating performance. This helps you chart future goals and strategies for sales, inventory, and operating overhead.