An income statement is simply known as a profit and loss statement (P&L), one of the most important types of financial statements used in determining a firm’s overall financial performance over any given period of time, quarterly or annually.
This statement will contain explicit information about the revenues and expenses of the company, making it a very important document that stakeholders must know about in terms of efficiency with which the business makes or spends income.
In this guide, w are going to discuss the key components, the usual formats, step the process of creating an income statement and some important tips for accuracy.
1. What is an income statement?
It is an income statement summarizing a company’s performance for a particular period, showing revenues earned, expenses incurred, profits, or losses
An income statement’s primary purpose is to show whether a company is profitable. It answers questions like:
•What are the revenues of the business?
•How much does it cost to produce goods or offer services?
•Is the company profitable or operating at a loss?
The income statement helps with investment decisions, pricing decisions, and cost management decisions. In addition, the income statement is commonly used as a tool for analysing trends of the company’s financial performance.
2. Major Components of an Income Statement
An income statement usually consists of the following key components:
• Revenue (Sales)
This is the income realized from the company’s primary operations, which may involve selling products or services.
• Cost of Goods Sold (COGS)
The direct costs of producing goods or delivering service. Such costs encompass materials, labour, and manufacturing.
• Gross Profit
Revenue less COGS will give the profit made after all the costs of the production have been accounted for.
• Cost of Operations (Operating Costs)
These are the operating expenditures of a business, which keep the business running day by day, such as rent, salaries and wages, utilities, and marketing.
• Operating Income (Operating Profit)
Gross profit minus all the operating costs. It demonstrates the profit of main business operations.
• Non-Operating Income and Expenses
Not being a part of core business operations, these include interests, investment gains or losses and taxes.
• Net Income (Net Profit)
The difference between total revenues and total expenses in net earnings or loss for the period.
3. How to Prepare an Income Statement
We will prepare an income statement step by step.
Step 1: Choose a Period
First, identify the period of which you are preparing the income statement. Some common reporting periods are:
• Monthly
• Quarterly
• Annual
This will depend on the objective of the income statement and the need for conducting financial analysis by the business.
Step 2: Gather the Financial Data
Gather all the financial data about the revenues, COGS, operating expense, and non-operating items. Gather data from the general ledger, accounting software, or other financial records so as to ensure the data collected are correct.
Step 3: Calculate the Total Revenue
Total revenue is the income earned from the sale of products or services. State all sales and revenues acquired by the firm for the period under review. Apply the following formula:
Total Revenue = Sales Revenue + Other Revenue sources (if any)
For a better illustration, if the firm made $500,000 from sales of products and $50,000 from service revenues, total revenue would stand at $550,000.
Step 4: Determine Cost of Goods Sold (COGS)
This account consists of direct costs incurred while producing or delivering goods and services. Direct costs consist of raw materials, labour costs, and expenses at the factory. Determine using the formula: COGS = Opening Inventory + Purchases – Closing Inventory
where opening inventory is $50,000, purchases are $200,000, and closing inventory is $30,000. Then,
COGS = $50,000 + $200,000 – $30,000 = $220,000.
Step 5: Calculation of Gross Profit
This can be determined by subtracting the COGS from total revenue. Gross profit depicts the amount of profit left after the cost of production as well as production costs have been subtracted from the core business operation.
Gross Profit = Total Revenue – COGS
Using our example:
G.P = $5,50,000 – $2,20,000 = $3,30,000
Step 6: Calculate Operating Expenses
Operating expenses are the cost of running your business other than the production. Common operating expenses are:
Rent
Salaries and wages
Utilities
Marketing and advertising
Office supplies
Make a list and add these up. We may assume that total operating expenses sum to $150,000.
Step 7: Calculate Operating Income (Operating Profit)
EBIT or Operating Income: This is the profit accruing from ordinary activities of a business. It is derived from gross profit by subtracting operating expenses.
Operating Income = Gross Profit – Operating Expenses
Using the above Example:
Operating Income = $3,30,000 – $1,50,000 = $1,80,000
Step 8: Add Non-Operating Income and Expenses
Non-operating income and expenses are revenues and expenses that do not bear any nexus with the business’s core operations. These may include:
•Interest income or interest expenses
•Gain or loss from sale of assets
•Other nonrecurring items
For instance, assuming that the firm has an interest cost of $10,000 as below:
Net Income Before Taxes = Operating Income – Interest Expense
= $1,80,000 – $10,000 = $1,70,000
Step 9: Compute Taxes
Tax is deducted from the net income before tax to come up with the final net income. Tax rates vary geographically, but for this illustration purposes, we shall assume a tax rate of 30%.
Tax = Net Income Before Taxes x Tax Rate
= $1,70,000 x 0.3 = $51,000
Step 10: Calculate Net Income (Net Profit)
Deduct tax from the net income before tax to get net income, that is, the ultimate profit or loss for the period.
Net Income = Net Income Before Taxes – Tax
= $1,70,000 – $51,000 = $1,19,000
Let’s take our example:
This is the last figure, which is the profit for the company during the reporting period.
4. Example of an Income Statement
Let’s consider an example of the income statement on the basis of our above calculations:
Income Statement | Amount ($) |
Revenue | 550,000 |
Cost of Goods Sold (COGS) | (220,000) |
Gross Profit | 330,000 |
Operating Expenses | |
Rent | 20,000 |
Salaries and Wages | 100,000 |
Utilities | 10,000 |
Marketing | 20,000 |
Total Operating Expenses | (150,000) |
EBIT | 180,000 |
Non-Operating Expenses | |
Interest Expense | (10,000) |
Net Income Before Taxes | 170,000 |
Taxes (30%) | (51,000) |
Net Income | 119,000 |
It would mean that in this case, the firm would take into consideration all the expenses and taxes and obtain a net income of $119,000.
5. Tips on Accurately Preparing the Income Statement
• Data Accuracy
Make use of valid data from sources like a general ledger and accounting software to result in correctness.
• Standardize Format
Keep an income statement standardized so that performance can easily be compared period after period.
• Set Core and Non-Core Business Income/Expenses Apart
Separate income expenses from non-core income expenses, which can enable some clear activities that can help explain the operational performance.
• Prepare Comparison Ratios
After preparing an income statement, it would be helpful to prepare key financial ratios for the Gross Margin and Operating Margin to understand the profitability status of the company.
• Error Proof-check entries
Check on any misclassifications and possible omissions of entries to have errors out of your financial statements.
Conclusion
A major part of financial reporting is preparing an income statement, which helps to shed the light on how profitable a company is. Business organizations, through the systematic recording of revenues and expenses as well as consistency, can trace and track their performance efficiently.
This is not merely meant to record profits or losses but is also a tool for better planning, budgeting, and decision making in making a business organization grow and become more competitive.