Creating an income statement
This document is key to understanding your business's finances.
The goal of any business is to earn a profit. Without accurate accounting, though, it can be hard to know if you're on track. Creating an income statement will give you timely information about whether your business is making money.1
"The income statement is important because it measures a company's income or loss for a period of time," says Jerry L. Mills, founder and CEO of B2B CFO, a consultancy firm that helps small businesses with cash management.
1 "Profit and Loss Statement - P&L." Investopedia. (2015) http://www.investopedia.com/terms/p/plstatement.asp
"Profit and Loss Business Builder Booklet." Zions Bank. https://www.zionsbank.com/pdfs/biz_resources_book-3.pdf
How to prepare an income statement
As you get your business up and running, create income statements monthly to monitor financial progress. Once you're established, prepare them quarterly or yearly. SMEtoolkit.org offers a free income statement template online.
Income statements add up all revenue and then subtract all expenses. The result is your net income or profit.
Whether on paper or electronically, start by listing each of the following line items that your income statement must contain and their corresponding amounts. Then, do the math.1
1 "Example Profit and Loss Statement." Small Business Development Corporation. (2015) http://www.smallbusiness.wa.gov.au/business-topics/money-tax-and-legal/money-matters/understand-your-accounts/understanding-profit-loss-statements/components-of-a-profit-and-loss-statement/example-profit-and-loss-statement/
Income statement line items
Time period: Income statements examine your profits and losses for a specific period: monthly, quarterly, or yearly.1 Include this information in the document’s heading.
Net sales: This line item shows your business's total revenue from sales for the time period you’re examining. Net sales do not equal your total profit, however.
Cost of goods sold: This section summarizes the money you spent to sell your goods, including inventory purchases, material costs, and shipping expenses. You'll subtract the cost of goods sold from net sales to determine your gross margin of sales.
Gross margin: This line item shows the difference between your net sales and the cost of goods sold. For example, $300,000 (net sales) - $200,000 (cost of goods sold) = $100,000 (gross margin).
1 "How Often Do You Need to Prepare a Business Profit & Loss Statement?" Demand Media. (2015) http://smallbusiness.chron.com/need-prepare-business-profit-loss-statement-55177.html
Income statement line items
General expenses: This section includes overhead and administrative expenses, including administrative payroll, rent, utilities, printing, and insurance. Your gross margin will be used to cover these, so subtract general expenses from your gross margin in order to get your net operating profit.
Net operating profit: This line item shows the difference between your gross margin and general expenses. For example, $100,000 (gross margin) - ($40,000) general expenses = $60,000 (net operating profit).
Net profit: This final line item subtracts the cost of taxes from your net operating profit. For example, $60,000 (net operating profit) - $20,000 (taxes) = $40,000 (net profit). This figure represents your ultimate profit or loss.
Why do I need to create income statements?
While cash flow statements zero in on the movements of your cash, income statements can give you the bigger financial picture.
Income statements show you how much money you have to reinvest in your business after costs, where expenses are adding up, and how your business is performing over longer periods. This information can help you identify how to make your operations more cost-efficient and guide other financial decisions.
Income statements are also important for taxes and financing. The Internal Revenue Service (IRS) requires these documents to assess taxes on your profits, and most banks will request them before granting funding.
Prepare income statements carefully
Keep careful financial records, and establish budgets that you can use to check your statements against to ensure your business is performing at the level you'd like and that your expenses are affordable. If you know your average expenses, you'll be able to pick up on variations and catch errors quickly.
"You should have a budget for every line item," Mills says. "That way, you can see if things are out of whack."
Another common mistake, Mills says, is submitting an income statement to a potential lender without an accompanying balance sheet, which shows investors what a company owns and owes as well as shareholders' equity, which are indications of financial health on a specific day.1
"The accuracy of the income statement is dependent on how well you do on your balance sheet," Mills says. These documents should be analyzed together, so don't forget to prepare both.
1 "How Does the Income Statement Relate to the Balance Sheet?" Demand Media. (2015) http://smallbusiness.chron.com/income-statement-relate-balance-sheet-55418.html