How To Read An Income Statement

by | Feb 1, 2022 | Accounting

As a busy service-based business, you know the importance of business financial reports. There are three main financial reports business owners study: the income statement, balance sheet, and statement of cash flows. Each gives vital information about how your business is performing. In this article we will focus on how to read an income statement and glean relevant information.

What Is The Income Statement?

The income statement (also known as the profit and loss statement) is a report that details the revenue and expenses of your business over a specific period. For example, a typical income statement covers a period of one year, but income statements can be generated monthly or quarterly.

Think of the income statement as a movie that tells the story of your service-based business’s performance over a certain period of time. They are useful to see if profit goals and sales forecasts are being met, and help determine future business decisions. Outside investors look to the income statement to help gauge whether to invest in certain businesses.

What Are The Key Income Statement Terms?

It is important to learn the important terms to read an income statement effectively. Let’s look at the important terms on the income statement of a service-based business:

  • Service Revenue – The gross revenue received from providing services
  • Cost of Services – The business expenses incurred to provide clients services (Also known as Cost of Goods Sold for manufacturing companies)
  • Gross Margin (Gross profit) – The profit before other costs are deducted
  • Operating Expenses – expenses related to operating the business, including selling, general, and administrative expenses. Depreciation expense is also included with operating expenses
  • Operating Income (Operating Profit) – Gross margin less operating expenses
  • Interest Expense – costs related to paying business loans or lines of credit
  • Income Tax Expense – Estimated income tax for the year.
  • Net Income (Net Profit) – Operating Income less income tax expense and interest expense

Income Statement Example

Now that we have discussed the important terms on the income statement, let’s walk through a simple example to illustrate how to read an income statement.

ABD Corporation
Statement of Income
Year Ending December 31, 2021

Service Revenue$1,000,000
Cost of Sales500,000
Gross Margin (Profit)500,000
Operating Expenses100,000
Operating Income400,000
Interest Expense50,000
Income Tax Expense50,000
Net Income300,000

 

ABD is a service-based business that provides cleaning services for buildings. In the above income statement, ABD generated $1,000,000 in service revenue for the year ending 2021, which encompasses revenue from January 1, 2021 to December 31, 2021.

Next we see that ABD incurred $500,000 in business costs to generate the $1,000,000 in service revenue. This is known as the costs of sales. Subtracting cost of sales from service revenue gives us gross profit, or gross margin:

Service Revenue – Cost of Sales = Gross Margin (Profit)

($1,000,000 – $500,000) = $500,000

We proceed systematically to the next line, operating expenses. Operating expenses include rent, utilities, payroll, travel, depreciation, advertising, and other expenses.Subtracting operating expenses from gross margin gives us operating income. ABD incurred $100,000 in operating expenses during 2021:

Gross Margin – Operating Expenses = Operating Income

$500,000 – $100,000 = $400,000

You may be wondering why operating expenses are not included with cost of sales. Operating expenses are expenses not directly related to production of services. . For example, ABD must pay rent and utilities regardless of the number of buildings cleaned.

Now that we have operating income we must subtract interest expense to calculate income before income taxes:

Operating Income – Interest Expense = Income Before Income Tax Expense

$400,000 – $50,000 = $350,000

The final expense in our example is the income tax expense that must be deducted from $350,000 to reach net income.

Net Income = Income Before Income Tax – Income Tax

$350,000 – $50,000 = $300,000

Now that we have learned to read an income statement, let’s review some important principles:

  • It is important to keep track of calculations line by line to reduce the chance of errors
  • Each calculation provides the reader with important information
  • The ABD income statement is fairly basic. Revenues and expenses can be broken down further into more specific categories.
  • For example, ABD can have revenues from office cleaning, residential cleaning, and warehouse cleaning, instead of a single “cleaning revenue” category.

How Can I Use Income Statement Information?

Once we understand the income statement, it is time to put the information to practical use. As a service-based business, controlling costs is important. The cost of sales line in the income statement is the first place to look if your goal is to see if costs are under control.

Comparing the cost of sales of the current income statement to the company budget, or with the previous period’s income statement is a great way to detect excessive costs and make decisions that can improve business performance.

Another way to use income statement information is to compare each line item as a percentage of total revenue. In the ABD example above, we see that operating expenses are $100,000 while revenue is $1,000,000. Therefore, operating expenses are 10% of total revenue. This method is useful to determine areas of high cost and high profit.

Summary

To review, income statements are summaries of total revenues and expenses for a company over a certain period of time. Readers can use the income statement to gauge a company’s profitability and cost structure.

We hope this article is helpful in learning how to read an income statement. For more information on accounting and business, be sure to visit the rest of our website!