Use the income statement to measure business revenues vs. expenses.
The income statement measures all your revenue sources vs. allyour business expenses for a given period. Let's consider anapparel manufacturer as an example in outlining the majorcomponents of the income statement:
- Sales: This is the gross revenues generated from thesale of clothing less returns (cancellations) and allowances(reduction in price for discounts taken by customers).
- Cost of goods sold: This is the direct cost associatedwith manufacturing the clothing. These costs include materialsused, direct labor, plant manager salaries, freight and other costsassociated with operating a plant (i.e., utilities, equipmentrepairs, etc.).
- Gross profit: The gross profit represents the amount ofdirect profit associated with the actual manufacturing of theclothing. It is calculated as sales less the cost of goodssold.
- Operating expenses: These are the selling, general andadministrative expenses that are necessary to run the business.Examples include office salaries, insurance, advertising, salescommissions and rent.
- Depreciation: Depreciation is usually included inoperating expenses and/or cost of goods sold, but it is worthy ofspecial mention due to its unusual nature. Depreciation resultswhen a company purchases a fixed asset and expenses it over theentire period of its planned use, not just in the year purchased.The IRS requires certain depreciation schedules to be followed fortax reasons. Depreciation is a noncash expense in that the cashflows out when the asset is purchased, but the cost is taken over aperiod of years depending on the type of asset.
Whether depreciation is included in cost of goods sold or inoperating expenses depends on the type of asset being depreciated.Depreciation is listed with cost of goods sold if the expenseassociated with the fixed asset is used in the direct production ofinventory. Examples include the purchase of production equipmentand machinery or a building that houses a production plant.
Depreciation is listed with operating expenses if the cost isassociated with fixed assets used for selling, general oradministrative purposes. Examples include vehicles for salespeopleor an office computer and phone system.
- Operating profit: This is the amount of profit earnedduring the normal course of operations. It is computed bysubtracting operating expenses from gross profit.
- Other income and expenses: Other income and expensesrepresent those items that do not occur during the normal course ofoperation. For instance, a clothing maker does not normally earnincome from rental property or interest on investments, so theseincome sources are accounted for separately. Interest expense ondebt is also included in this category. A net figure is computed bysubtracting other expenses from other income.
- Net profit before taxes: This represents the amount ofincome earned by the business before paying taxes. It is computedby adding other income (or subtracting if other expenses exceedother income) to the operating profit.
- Income taxes: This is the total amount of state andfederal income taxes paid.
- Net profit after taxes: This is the "bottomline" earnings of the business. It is computed by subtractingtaxes paid from net profit before taxes.
Excerpted from Start Your Own Business: The Only Start-UpBook You'll Ever Need, by Rieva Lesonsky and the Staff ofEntrepreneur Magazine, © 1998 Entrepreneur Press