A complete no geek-speak explanation of your Income Statement in Three Parts

Every Income Statement tells its own Story
and that story can be incredibly useful for improving your business and making more profit

Income Statements Explained – Layout finally mastered – this year, instead of simply signing the paperwork and paying the tax, arm yourself with some extra knowledge and use that information to your profitable advantage.
Income Statements (also known as a Profit and Loss Statement) give a report on the trading history of a business – they records all the “INs and OUTs”.
This history can be reported to show the story of a week, a month, or a year of activity. In other words the major aim of an Income Statement is to summarise, for a given period of time, the revenue received against the related expenses that the company had to spend.
There are Three Steps to mastering your Income Statement once and for all;

  • Step 1: Master the Accounting Conventions
  • Step 2: Master The Elements – Conventional Headings
  • Step 3: Master the Format – Conventional Layout

Income Statements Explained – Conventions Mastered – Step 1

How an income Statement is laid out is dictated by convention – understand why they are all much the same and how the conventions work.

Income Statements Explained – Elements Mastered – Step 2

All the details on what the breakups of each Revenue and Expense Heading means, and how the categories are important for driving better management decisions.
Staying mindful of the type of business in front of you will help you retain context and better understand the specific story that Income Statement is telling.

Income Statements Explained – Layout Mastered – Step 3

Layers explained

The Profit and Loss report was invented to enable informed decision making; – it is a standardised information source used to assess outcomes and thereby guide actions. Listing out a whole lot of revenues and expenses and then coming up with a total at the bottom is great for calculating taxes; but to make understanding the story of what happened simpler, most are multi-layered. What this means is they include sub-totals and totals through-out the report. Think of it as sub-sections that add together to create a whole. Sub-totals are included in the Income Statement, thereby creating layers of information and creating “chapters” with in the overall story of the report.

Gross Profit (Gross Revenue, Gross Margin or just plain Income):
Subtracting the cost of creating the item sold from the sale price of the item. This sub-total adds together all Revenues and then subtracts the cost of the Direct Expenses related to those income streams.
It is a key indicator especially for businesses selling products because it indicates how efficiently a business is using it materials and labour in the production process and hits on how appropriate the selling prices are.

Operating Profit (EBIT or Earnings before Interest Tax, Gross Profit less Indirect Expenses):
The profit from day-to-day running (operations) of the core business – it is the difference between the Revenues and Costs generated by ordinary core activities. It typically excludes interest expense, tax expenses and non-recurring items (such as accounting adjustments, legal adjustments, and one-time extraordinary transactions), and other items not directly related to a company’s core business operations.
This total is especially useful for assessing how well the business and its management are performing – all of the line items up to this point should be within the control of the CEO (or general manager or whatever title is given to the head honchos in charge). It measures both overall demand for the company’s products/services (sales) and the company’s efficiency in delivering those products/services (costs).

Profit (Earnings. Net Income, Net profit, Net Earnings):
The crux of everything; all income less all expenses – and indicates what is left over as a result of running the business for re-investing, returning to shareholders, repaying loans etc.
This is where it all leads to and this is the final indicator of a company’s financial situation/profitability for an accounting period. This is however true in the case where the gross profit is greater than the expenses; the opposite can also be true in certain unfortunate cases, where the term Net Loss is used instead. Some of these profits are paid to the shareholders/owners in the shape of dividends and the rest of them are transferred to equity as retained earnings.

Losses – Operating Loss or Net Loss:
The opposite can also be true in certain unfortunate cases where Revenue is LESS than the overall expenses. In SME’s and Micro’s sometimes this is considered “desirable” as it minimises the amount of business tax paid – however losses also create an increase in the amounts Owed by the business and/or indicate unsustainable future operations.

Inconsistencies to Conventional Layout

Whilst this section has discussed “Conventional Layout” in practice there are many forms of convention! Don’t get upset if the Income Statement you are looking at varies slightly.
One of the most powerful tricks accountants have up their sleeves, especially in very large companies where directors are constantly trying to justify their jobs (and salaries) to shareholders is to mess about with what goes where to create a veil of confusion and make everything look fine. Enron, etc are fabulous examples of where this “Sleight of hand” enabled misconduct to continue for years.

Depreciation and Amortisation:
In some businesses the Depreciation and Amortisation (costs of “using up assets”) are considered to be part of operations and will form part of the Indirect Expenses ie Depreciation costs are considered to be within managers’ day-to day control. In others it is separated out of operating expenses. Depreciation rates in many countries are mandated by the government to ensure standardisation and easy comparisons. If considered non-operational Depreciation and amortisation are included in the Income Statement AFTER Operating Profit in which case the Operating profit may also be called EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation).

Interest Expense:
If the management initiate the interest as part of day-to day operations it should be included as an Indirect Expense – eg interest charged on credit cards issued to staff, or interest incurred for late payment of suppliers. On the other hand Interest relating to the purchase of major equipment, or a building is more likely to be negotiated by the shareholders/directors of the business and therefore is best reflected under the Other Expenses. In smaller owner/operated businesses interest is often not reflected separately, but included as part of Indirect Expenses regardless of what it is related to.

Adding in these layers gives more details and creates a clearer understanding about where things are going well and where things may be less than optimal:

  • Are sales as expected?
  • Did we spend too much on raw materials?
  • or too much on overheads?

Income Statements are the most useful reports EVER as long as the story they are telling is used by management to uncover:

What decisions need to be improved?

What decisions can be improved next?