Use the income statement to measure business revenues vs. expenses.
The income statement measures all your revenue sources vs. all your business expenses for a given period. Let's consider an apparel manufacturer as an example in outlining the major components of the income statement:
- Sales: This is the gross revenues generated from the sale of clothing less returns (cancellations) and allowances (reduction in price for discounts taken by customers).
- Cost of goods sold: This is the direct cost associated with manufacturing the clothing. These costs include materials used, direct labor, plant manager salaries, freight and other costs associated with operating a plant (i.e., utilities, equipment repairs, etc.).
- Gross profit: The gross profit represents the amount of direct profit associated with the actual manufacturing of the clothing. It is calculated as sales less the cost of goods sold.
- Operating expenses: These are the selling, general and administrative expenses that are necessary to run the business. Examples include office salaries, insurance, advertising, sales commissions and rent.
- Depreciation: Depreciation is usually included in operating expenses and/or cost of goods sold, but it is worthy of special mention due to its unusual nature. Depreciation results when a company purchases a fixed asset and expenses it over the entire period of its planned use, not just in the year purchased. The IRS requires certain depreciation schedules to be followed for tax reasons. Depreciation is a noncash expense in that the cash flows out when the asset is purchased, but the cost is taken over a period of years depending on the type of asset.
Whether depreciation is included in cost of goods sold or in operating expenses depends on the type of asset being depreciated. Depreciation is listed with cost of goods sold if the expense associated with the fixed asset is used in the direct production of inventory. Examples include the purchase of production equipment and machinery or a building that houses a production plant.
Depreciation is listed with operating expenses if the cost is associated with fixed assets used for selling, general or administrative purposes. Examples include vehicles for salespeople or an office computer and phone system.
- Operating profit: This is the amount of profit earned during the normal course of operations. It is computed by subtracting operating expenses from gross profit.
- Other income and expenses: Other income and expenses represent those items that do not occur during the normal course of operation. For instance, a clothing maker does not normally earn income from rental property or interest on investments, so these income sources are accounted for separately. Interest expense on debt is also included in this category. A net figure is computed by subtracting other expenses from other income.
- Net profit before taxes: This represents the amount of income earned by the business before paying taxes. It is computed by adding other income (or subtracting if other expenses exceed other income) to the operating profit.
- Income taxes: This is the total amount of state and federal income taxes paid.
- Net profit after taxes: This is the "bottom line" earnings of the business. It is computed by subtracting taxes paid from net profit before taxes.
Excerpted from Start Your Own Business: The Only Start-Up Book You'll Ever Need, by Rieva Lesonsky and the Staff of Entrepreneur Magazine, © 1998 Entrepreneur Press