An income statement is the financial story of your business—a monthly, quarterly, or annual tally of revenue minus expenses. It’s also called an earnings statement or a profit-and-loss statement. It answers the question, “How profitable is your business?”
Yet it’s a mystery to many entrepreneurs, even as public companies must publish the details of their income statements quarterly. (Apple, for example, made $90.1 billion in revenue with a 43.06% gross margin in Q4 2022.)
Other companies have exploited outsiders’ perception of corporate finance as a black box. Enron, infamously, conjured revenue from projections, made losses vanish from its books, and touted a too-good-to-be-true income statement that many believed for far too long.
These are outliers—not reasons to be intimidated. We’ll help you put together your first income statement.
What is an income statement?
An income statement is a financial statement that reports a company’s financial performance. It shows you the company’s income and expenditures over a specific period of time.
The income statement is also known as a profit and loss statement, statement of operations, or earnings statement.
Income statements vs. balance sheets
The income statement shows all revenue and expense accounts for a specific period. The balance sheet and cash flow statement are different; each offers a different vantage point of the same financial landscape. Combined, the three statements assess a company’s financial health and inform financial forecasts.
The most confusion comes when comparing balance sheets and income statements. A few key differences help clear things up:
- Balance sheets are a snapshot in time (e.g., “as of October 15, 2021”); income statements are summary metrics for a longer period (e.g., “for Q3 2021”).
- Balance sheets weigh assets against liabilities instead of revenue against expenses.
- A balance sheet’s summary metric is “owner’s equity” instead of “net income.”
Balance sheets help answer the question “How much is this business worth?” instead of “How profitable is this business?” The former is a question of business solvency; the latter is a question of business performance.
Valuable businesses aren’t always profitable, and vice versa. For example:
- A valuable company could be unprofitable for years. Think of high-growth startups using venture capital—not revenue—to expand.
- A profitable business may have huge liabilities looming ahead. Think of auto manufacturers and their underfunded pension plans.
A good, if imperfect, parallel is a government’s deficit (i.e., income statement) versus its debt (i.e., balance sheet). If, for now, you’re president of a one-person enterprise, not a nation state, you have a few more choices to make.
Importance of income statement
The income statement can help a small business owner identify areas that are profitable and those that need to be improved or adjusted. It also has the following advantages:
- Helps you understand revenue. Income statements include revenue as well as expenses. These include costs of goods sold, operating expenses, and other business expenses. The income statement provides a company’s net income or net loss by subtracting total expenses from total revenue. Business decisions, such as expanding or shrinking operations, can be influenced by this figure, which is a critical indicator of financial health.
- Makes company analysis simple. A company’s income statement also provides valuable information to investors, lenders, and other stakeholders. It can increase investor confidence and the likelihood of securing financing or other investments by providing detailed information on revenues and expenses.
- Allows for frequent reporting. Business owners monitor progress, identify trends, and find potential problems or opportunities on an income statement regularly. By adjusting operations, a business owner can keep profitability in check if expenses are continuously rising.
Basically, an income statement is a great tool for businesses of all sizes because it shows a company’s financial performance and can help them improve profitability.
Who uses an income statement?
You’ll probably create your first income statement for an audience of one: you. If a line-by-line breakdown of the minutia is more confusing than illuminating, your income statement isn’t doing its job.
One way to build a statement that will work: start with the basics and catalog follow-up questions, from you or others. Then, identify where a more detailed section—like a breakdown of marketing expenses between online and offline events—could proactively answer those questions.
If you’re looking for a loan or to raise capital, you’ll need to include more details and, almost certainly, create a multi-step income statement.
Lenders and investors want to know, for example, whether your gross profit is enough to sustain a positive net income as you scale (and incur more operating expenses). A tiny margin may make a one-person shop profitable; it may not work for a company of 20 or 200.
Outside funders will also compare your business to others, an insight you can take advantage of too. Through public company filings, industry benchmarks, networking events, or casual conversation, understanding your income statement will help you speak the same language as your fellow founders.
You’ll know how you compare, where you’re succeeding, and what to work on next.
The key components of an income statement
An income statement is usually compiled monthly, with monthly numbers tallied for quarters and years. Why monthly? Because one goal of an income statement is to keep a steady pulse on your business—to identify dips (or spikes!) when they affect a quarterly growth goal, not business solvency.
Here’s an example of an income statement.
To create an income statement:
- Start with sales revenue (physical products or services). You may have more than one revenue stream.
- Subtract the cost of goods sold (COGS). Costs include finished products, raw materials, labor, etc. (some service products may also have costs).
The resulting number is your “gross profit.” From that number, subtract expenses for:
- Marketing and sales (e.g., Google Ads campaigns, trade show booth)
- General and administrative (e.g., salaries, office space, warehousing)
If your business is divided into departments or has unique expenses (e.g., industry-specific research), you may subtract those as line items, too.
The resulting number is your EBITDA, or earnings before interest, tax, depreciation, and amortization. It’s your gross profit minus expenses.
Income statements sometimes separate operating from non-operating expenses and revenue to keep one-off gains or losses from distorting the financial picture of the business. The “right” level of granularity depends on who’s looking at your income statement and for what purpose.
From your EBITDA, subtract:
- Depreciation and amortization expenses (e.g., portions of big-ticket items).
Now you have your “operating income,” which is also called your earnings before interest and tax (EBIT).
The final steps for your income statement tackle the remaining letters in the acronym:
- Subtracting interest expense or adding interest earned, which gives you your EBT (i.e., pre-tax income).
- Subtracting income tax expense paid on your EBT.
The result is your net income or net earnings—the bottom-line number on your income statement. It’s also the first step in creating two other financial reports.
How to read an income statement
If you’re using a financial accounting software to generate these financial statements, you’ll need to know how to read them.
Here’s how to read your income statement:
- Look at the company’s revenue section. Here you’ll find the total amount of money earned during the reporting period. It shows your ability to generate sales. Look for trends in revenue over time and compare them to benchmarks to understand how your company is performing.
- Examine COGS. This is the total cost of sales or services, or the costs incurred to produce your products, including materials and labor. A rising COGS can indicate increased costs or a decline in the efficiency of your production process.
- Calculate gross profit. Gross profit is the difference between revenue and COGS. It represents the profit a company makes before accounting for operating expenses.
- Look at operating expenses. Operating expenses include rent, salaries, and marketing expenses. They are deducted from gross profit. They can be broken down into categories such as research and development, sales and marketing, and general and administrative expenses.
- Calculate operating income. An operating income is the profit a company makes after all its expenses are paid.
- Look at other income and expenses. There are other expenses and income, including interest income, investment gains, or one-time expenses such as legal settlements. Items like these can affect a company’s profitability. Consider how any unusual gains or losses might affect the company’s long-term performance.
- Calculate net income. After all expenses have been accounted for, you can determine a company’s net income and net profit.
Note that your income statement will look much different than that of a publicly traded company. Like Apple, for example, whose comprehensive income statement includes metrics like earnings per share (EPS). Yours will be more simple and reflect the template above.
How to create the right type of income statement
Good accounting helps you understand how your business is doing. The complexity of questions you have—and the type of income statement that will serve you best—will grow with your business.
Even if you’re creating your first income statement, you have a couple choices to make:
1. Horizontal versus vertical analysis. A horizontal analysis uses absolute numbers for each metric—real dollar amounts (e.g., $40,000 in gross profit in 2022). It ensures reporting is in accordance with generally accepted accounting principles (GAAP).
Most outsiders peeking at your finances prefer a horizontal analysis because it offers actual numbers. It’s easier to spot big contributors to an increase or decrease in profitability.
A vertical analysis, by contrast, uses relative measurements—percentages of a base number (e.g., 30% of expenses came from marketing). A vertical analysis makes it easier to understand the relationships among items on your income statement. It’s also a useful tool for comparing yourself to industry peers or benchmarks.
You can use both analyses, adding a parenthetical percentage (for vertical analysis) to the right of a hard number (for horizontal analysis).
2. Single-step versus multi-step income statement. A single-step income statement is a single formula with a single summary metric:
Revenue - Expenses = Net income
Typically, revenue and expenses are single line items. For example, “revenue” may not separate sales from the COGS.
A multi-step income statement, like the one outlined at the start of this article, uses more line items and generates summary metrics from three sequential formulas:
- Sales - COGS = Gross profit
- Gross profit - Operating expenses = Operating income
- Operating income ± Non-operating items = Net income
A more complex process offers more granular visibility into your financial situation. As you can see, it gives you two numbers—gross profit and operating income—that a single-step process does not.
Gross profit shows the ability of your product or service to generate revenue, given the costs of production. Operating income assesses the efficiency with which you sell that product or service.
Do you really need those additional figures? It depends with whom you’re sharing them.
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Income statement FAQ
What is an income statement and its purpose?
What are the 4 parts of an income statement?
- Revenues: this is the money a business earns from selling its goods and services.
- Expenses: this is the money a business spends to produce and deliver its goods and services.
- Profits: this is the difference between revenues and expenses.
- Retained Earnings: this is the portion of profits that are reinvested in the business and not distributed to shareholders as dividends.