What is an Income Statement?

What is an Income Statement? | Accounting Smarts
Charles Hall

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Charles Hall

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March 1, 2021

The income statement is one of the most important financial statements of an organization. You may also hear it referred to as a Profit and Loss Statement or P&L Statement.

The income statement is one of the most important financial statements of an organization. You may also hear it referred to as a Profit and Loss Statement or P&L Statement.

The income statement reports the financial activity and profits of an organization for a specific period of time and consists of 3 primary components: REVENUE - EXPENSE = PROFITS. One glance at the bottom line reveals the profitability of the organization.

The income statement summarizes all operating activities of an organization into a single statement. There is much more to an income statement than just profit or loss so let’s take a deeper look into the components of an income statement.

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What is an example income statement?

A picture tells a thousand words so let’s start with an example of a typical small business income statement. When you understand the basic concept of this statement you can apply it to any size organization whether it is small, medium or large. Descriptions may change but the concept does not.

You can download this free income statement template and then customize it for your organization.

Download Free Income Statement Template

income-statement-example

What are the components of an income statement?

Most income statements are structured the same way and in the same order:

  • Income
  • Cost of Goods Sold
  • Gross Margin
  • Operating Expense
  • Profits

Header

Any accounting statement always begins with the header. It defines the company, the report and the period of time covered. Typically, an income statement is prepared at the end of each month and the end of each year. This frequency allows organizations to compare results month to month or year to year to identify potential errors or trends. Comparing prior periods is a great analytical tool.

Income Section

This section should be self-explanatory, it includes all the sales transactions related to the business. Whether the business offers goods or services it is still income. Sales can be segmented to more easily track different income streams. The example above includes sales and relates to all sale of products.

There is also a line item called “Shipping and Handling” which relates to income from charging customers for expedited shipping.

A service organization may have income streams from consulting or the sale of training materials. Segmenting is up to the organization based on what level of tracking they want to do.

Cost of Goods Sold Section

Cost of goods sold or COGS as it is commonly referred to, is the cost associated with the sale of a product or service. Because of the relationship between income and COGS they are positioned next to each other. As sales increase, COGS should increase. As sales decrease, COGS should decrease. This relationship is typically expressed as a percentage of COGS to Sales. In the example above if you divide $1,380,687 / $2,711,310 you get 50.9% which means almost 51% of each sale relates to COGS.

As an example, a custom pin company sales 100 pins for $300. The cost to produce the 100 pins is $140. This $140 represents the COGS. If there is no sale, there is no COGS.

As a service example, a janitorial service generates $1000 a month for cleaning service for a large business complex. The business incurs labor costs of $300 per month for actual cleaning. This $300 represents the COGS. If there is no cleaning, there is no sale and no COGS.

COGS is considered a variable expense which means it is only incurred if a sale is made.

COGS is typically a very large portion of an organization's expense and therefore is monitored closely. If you can reduce COGS it has a big impact on the bottom-line profit.

TIP: COGS can be improved by negotiating lower cost with vendors, buying in bulk, controlling labor costs or improving manufacturing efficiency.

Gross Profit

Gross profit also known as gross margin is simply the difference between Income and COGS. It is the amount left over that is used to cover fixed costs. The higher the gross profit the better.

A service industry organization likely has a gross margin percentage less than 20%. A product-based business likely has a gross profit percentage 50% or higher. Whatever a company’s gross profit, that is what they have to manage their fixed expenses too to ensure they have a profit at the end of the day.

TIP: Gross profit can be improved by increasing sales or decreasing COGS.

Expense

Expense is a broad category with many different subcategories. Expenses are also known as operating expenses or fixed costs. These are costs that are incurred because you operate a business. They are incurred regardless of making any sales. They are fixed because they have no relationship to sales and must be paid.

A business may have a building, utilities, management, advertising etc. All of these things are independent of sales. Rent has to be paid. If you have a building it requires utilities. Management salaries have to be paid.

In the example income statement above, you will notice shipping charges and credit card fees. These are really variable expenses as there would be no shipping charge unless you sold a product or there would be no credit card fees unless you made a sale and charged a credit card. These are considered variable expenses and could be included in the COGS above. It is up to each company how they present them on their income statement.

It is wise for a company to track expenses in subcategories for analysis and decision-making purposes. It is easy to compare a line item month over month if it is broken down into a specific type of expense.

As an example, let’s assume Telephone expenses went from $3000 last year to $5,659 this year as listed above. That is a large increase and would raise a red flag demanding more research.

TIP: An effective way to analyze fixed expenses is to compare the prior period to the current period to identify significant changes. In addition, by calculating each line item expense as a percentage of sales, you see the relationship to sales and how it may change as sales increases or decreases.

Profit

Profit, Net Income or Net Loss is the last line on the income statement. If you are picking up an income statement of an organization for the first time you most likely will look at the top line first and then immediately go to the bottom line.

Total Income and Total Profit may be the most intriguing numbers. Total income gives some idea of how large a company or at least puts it in perspective. And of course, profit is the name of the game.

Bigger is not always better as small businesses often produce higher profits than companies double their size. As a business grows it requires more overhead meaning more fixed expenses and puts pressure on profit.

Profit is what is left after all expenses have been considered. Any profit is good, but get into the 5% to 20% and you will be the envy of any business owner.

What is the difference between an income statement and a balance sheet?

An obvious question when speaking of the income statement is: “What is the difference between the income statement and the balance sheet?”. An income statement reports the activity of a business over a period of time by showing revenue, expense and profit. A balance sheet reports the financial condition of a company at a single point in time by reporting assets, liabilities and owner’s equity.

The income statement and balance sheet go hand in hand as the profit of the income statement flows into the owner’s equity on the balance sheet.

By using both statements you can learn a great deal about the health and effectiveness of an organization.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

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