How to Prepare an Income Statement for Your Business
As far as financial records go, income statements are one of the most important. They’re used to show a profit and loss over a period of time, which is essentially everything you need to know to gauge how a company is doing.
As one of the three core financial statements (the other two being a balance sheet and a statement of cash flows), the income statement specifically focuses on a company’s revenue and expenses — and ultimately, its success as a profit-generating company.
The following sections explain what an income statement is, the different parts that are included, and its importance in understanding a company’s worth. Knowing how to create and read an income statement will help you see if your business is earning or losing money, and serve as a guide on how you can best grow your business moving forward.
What Is an Income Statement?
The income statement actually covers four key areas — revenue, expenses, gains, and losses. It starts by taking account of all the company revenue streams and subtracting its expenses. The statement continues working its way through each line until either a net profit or loss is realized.
The unique value of an income statement is that it clearly shows a company’s financial performance over a specific period of time, usually a month, quarter, or year.
An income statement is the first financial document you need to prepare. It comes before both a balance sheet and cash flow statement, as it calculates the initial net income or net loss needed to prepare the other statements.
Parts of an Income Statement
Depending on the nature of its operations, every company will have its own specific income and expense details. For this reason, every income statement will naturally differ. There are, however, a few general line items that you can count on seeing in every income statement. These include the following:
This is the total sum of money a company receives, which mainly comes from three sources — operating revenue (primary income sources), non-operating revenue (secondary sources), and all other “gains.”
Operating revenue is all the money received by a company from primary business activities, such as the sale of products and services. Non-operating revenue, on the other hand, comes from secondary sources or non-core business activities, like rental income or capital interest. Gains are generally all other income received from miscellaneous activities, which can include the sale of any equipment, land, or other long-term assets.
All revenue is placed in the top line of the statement, although companies that have multiple revenue streams can break this down among several different lines.
An income statement accounts for revenue, not receipts. While revenue is marked during the period that sales are made, receipts are dated when the payment is actually received.
Expenses are all the costs incurred by a company to produce its revenue. They are usually listed in detail and make up the bulk of the income statement. Similar to revenue, expenses fall into three general categories — operating expenses (primary expenses), non-operating expenses (secondary expenses), and all other losses.
Operating expenses are those that are directly incurred during the company’s core activities, including payroll, rent, administrative expenses, cost of goods sold, or raw materials. Non-operating expenses are those that aren’t directly related, such as interest expense, income tax, employee separation payments, or currency exchange losses. Any other item is considered a miscellaneous loss, such as those that may result from lawsuit settlement charges or losses taken in the sale of long-term assets.
Net Income or Net Loss
This is the final number that results when you deduct all expenses from all revenue. If revenues are greater than expenses, the result is net earnings. If revenues are less than expenses, the result is a net loss. Since this figure is the final calculation in an income statement, it is often referred to as a company’s “bottom line.”
Income Statement Formats
There are two basic formats used to prepare an income statement — the single-step format and the multi-step format.
The single-step income statement is a simplified calculation that uses a single subtotal for all revenue line items, and a single subtotal for all expense line items. It subtracts the total expenses from the total revenues, resulting in a net profit or loss at the bottom of the report.
As the most basic income statement, it’s perfect for small businesses that have simple operations with only a few line items. However, not many businesses opt to use the single-step format as it gives an extremely pared down overview of the company’s financial status.
The multi-step income statement shows a more detailed picture of a company’s finances. It’s also the only choice for larger, more complex companies. The multi-step income statement requires several steps to reach the bottom line.
It starts by subtracting operating expenses from gross profit, which results in the subtotal income from operations. Other revenues are added and other expenses are subtracted from this number, which yields another subtotal income before taxes. Finally, all taxes are deducted, which produces the final net income or net loss for the period of time.
The extra elements in a multi-step income statement are the subtotals of gross income, operating income, pretax income, and after tax income.
Limitations of an Income Statement
It’s important to remember that income statements are only one of three essential financial statements. So although they are a key component in measuring a company’s profitability, they are also limited in many ways.
For example, the outcome of an income statement — whether a company shows net profit or loss — is greatly reliant on the accounting methods used to produce these figures.
If a company uses the FIFO (first-in, first-out) method, for instance, the line items will assume that the oldest inventory is sold first. The LIFO (last-in, first-out) method, on the other hand, will assume that the most recent inventory is sold first. This makes a big difference.
FIFO is considered the more transparent and trusted method. Not only does it follow natural operations, as most companies really do sell their older inventory first, it reflects the real cost of inventory and results in more accurate accounting.
Companies that use LIFO list the most recent inventory costs first, which are typically higher than older inventory costs. As such, profits often come out significantly lower and the company incurs a lower taxable income. Older inventory tends to remain in the books for a longer time period, usually until they have perished or are rendered obsolete.
Another accounting decision that creates variance in the income statement is whether the company chooses to use cash basis or accrual accounting. With cash basis, revenues are reported on the income statement when the cash is actually received from the customer, and expenses are reported when the cash is paid out.
With the accrual method of accounting, on the other hand, revenues are reported on the income statement when they’re actually earned — or when the invoice is sent out — which may occur before the cash is actually received.
Expenses in accrual accounting are reported when the company takes them on (i.e., when equipment is purchased, the expenses are reported at the time of the purchase, even if the equipment is purchased on a loan that won’t be paid off for some time). This is the preferred method of accounting and the only one that’s legally allowed for large corporations.
Another limitation of an income statement is that it accounts for items when they’re recorded — it doesn’t take inflation into consideration (which mostly affects long-term assets) and offers no predictive value (a company that shows a profit one term isn’t guaranteed to do so the next term).
An income statement also doesn’t take measure intangible assets. Say, for example, a company has spent a large amount on branding or product development. These items may help with future growth, but they’re not something that can currently be considered profitable.
The Importance of Your Income Statement
Income statements provide valuable insights into the most important aspect of a business — whether it’s operating at a profit or a loss. By detailing all the line items and organizing them in a clear, concise format, business owners, managers, and stakeholders can use the information provided by income statements to make better decisions and help guide the company toward a brighter future.
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