The income statement is a financial statement that reports on company revenue, expenses, and net income as of a specific time period, such as a month or year. The income statement is directly connected to the balance sheet, and both financial statements are created using the accrual basis method of accounting.
An income statement is also a valuable tool that business owners can use to make informed business decisions and improve company results.
Meet Bob
Bob is the owner of Tailwind Bikes, a bike manufacturer. Here is Tailwind’s income statement for the period ended March 31st, 2018:
Note that the income statement is for a specific period of time. This point is important because the balance sheet is created as of a specific date. While the income statement is connected to the balance sheet, they do not cover the same time periods.
Income Statement Formula
An income statement is generated using the income statement formula:
Revenue – expenses = net income (profit)
Revenue is defined as money paid in cash or owed to a business, based on sales and other activity during a month or year. Revenue includes sales of a product or service and other types of transactions. Tailwind generates revenue from sales, and from several activities that are defined as non-operating income, including interest income.
Expenses are costs incurred to generate revenue. Businesses incur product costs, which include materials, labor, and other spending that can be directly traced to the product or service. Period costs, on the other hand, are those incurred with the passage of time, such as interest expense on a loan.
In the case of Tailwind, the bike company incurs cost of sales that are directly related to bike manufacturing. The firm also incurs period costs, such as salaries for home office workers, which are listed as non-operating expenses. Labor costs for production are separated from salary costs for workers who are not involved in the manufacturing process.
Multi-Step Concept
Most companies, including Tailwind, produce a multi-step income statement, and this more detailed format documents how a firm produces net income. A multi-step income statement separates income and expenses into operating and non-operating categories.
Most of Tailwind’s business activity flows through gross profit:
$1,000,000 sales – $800,000 cost of goods sold = $200,000 gross profit
The materials, labor and overhead costs incurred to make bikes are posted to cost of sales. In March, the firm sold $1,000,000 in bikes, and the units sold had a total cost of $800,000.
Bob’s company incurred other expenses to operate the business in March, such as the cost to operate the home office. Operating expenses are subtracted from gross profit to calculate operating income:
$200,000 gross profit – $150,000 operating expenses = $50,000 operating income.
Operating vs. Non-Operating
Operating income is generated from the day-to-day activities of running your business. In March, bike sales produced $50,000 of operating income. The company also earned non-operating income, including $3,000 in interest income and a $1,500 gain from the sale of a machine.
$50,000 operating income + $4,500 non-operating income = $54,500 net income
Your business must be able to produce the vast majority of net income from operating income activities because operating income is sustainable. Non-operating income is not consistent or predictable, and no company can survive over the long-term by relying on non-operating income to produce annual profits.
In a similar way, Tailwind incurs operating expenses (cost of sales) and non-operating expenses that are not directly related to production. It’s important to assign both income and expenses into these categories, so that you can analyze your business results.
What Is Accrual Basis?
Almost all businesses post activity to the income statement using the accrual basis of accounting, in order to comply with Generally Accepted Accounting Principles (GAAP).
The accrual basis requires a company to match revenue earned with the expenses incurred to generate the revenue. This concept is also referred to as the matching principle, and it presents a more accurate picture of a company’s profitability.
When Tailwind sells a bike in March, for example, it will include materials and labor costs that are directly related to the bike that was sold. The materials, for example, may have been purchased in January, and the labor costs to make the bike may have been paid in February. The goal is to match revenue (sales) with direct expenses (material and labor), regardless of when the expenses are paid.
Other expenses in the income statement are period costs, which cannot be directly tied to a sale. Home office expenses, such as lease payments and insurance, are expensed during the period incurred.
Balance Sheet Connection
The income statement is connected to the balance sheet through the net income account.
Income statement accounts are referred to as temporary accounts because the account balances are adjusted to zero at the end of each month. Each of the account balances in Tailwind’s March income statement, for example, will be adjusted to zero at the end of March.
Balance sheet accounts, however, are permanent accounts, and the ending balances are carried forward from one month to the next.
At month-end, the accounting books are closed, and all revenue and expense accounts are adjusted to zero. The net impact of the income statement activity is posted to net income in the balance sheet.
When the March 2018 books are closed, the $54,500 in net income is posted as an increase to the retained earnings account in the balance sheet. The retained earnings balance represents the total earnings for Tailwind since the company’s inception, less all dividend payments to shareholders. A dividend is a share of company earnings.
Earnings Per Share
Net income is used to calculate earnings per share (EPS), which is a frequently used ratio to assess the value of a company’s common stock. Basic EPS is calculated as:
(Net income available to common shareholders) / (weighted average common stock shares outstanding)
If a company issues preferred stock, the firm is obligated to pay preferred stock dividends before using the net income to pay a dividend to common stockholders. Weighted average common stock shares outstanding refers to:
[(Shares held at the beginning of the period) + (Shares held at the end of the period)] / 2
If Tailwind produces $4,500,000 in annual net income available to common shareholders and has 3,000,000 weighted average common stock shares outstanding, the basic EPS is $1.50 per share.
When a business can increase earnings per share, the common stock is considered more attractive, and investors may drive up the price of the stock.
Data for Business Decisions
Here are some metrics to improve your business results, using information in the income statement:
- Gross profit: The vast majority of Tailwind’s expenses are incurred in cost of sales, and reducing the cost of sales will make the biggest impact on increasing net income. For example, Bob may be able to negotiate a lower price for component bike parts, which will reduce cost of sales and increase gross profit.
- Non-operating income: Bob should not count on non-operating income as a way to increase net income, because non-operating income is not consistent or reliable. Tailwind’s primary source of income is generated from manufacturing and selling bikes.
- Period costs: Keep in mind that many period costs, such as home office expenses, cannot be easily reduced. A lease on office space, for example, is fixed over a specific period of time, and this cost cannot be reduced to increase net income until a new lease can be negotiated.
As a business owner, you should take a close look at your income statement each month, and use these metrics to make business decisions.
More Than a Report
Many business owners feel overwhelmed, and they don’t take the time to analyze the financial statements they generate each month. Keep in mind that the income statement is more than a report of revenue and expenses. This document is also a useful tool for making informed business decisions.
Use these tips to improve your company results, using the income statement.
Theresa Todman, Managing Partner/CEO of B&M Financial Management Services, LLC . Theresa works with small business owners and entrepreneurs to assist them with financial management and creating organized systems and procedures. She specializes in bookkeeping, accounting, QuickBooks solutions, small business tax issues and consulting.
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