What Is an Income Statement?

by Jim Woodruff - Updated April 20, 2018
Finance.

Do you know how much profit your business is making? Do you receive an income statement on a regular basis? Do you know how to interpret the figures? An income statement is a vital tool for any small business owner or manager. These figures represent the score of the game. They tell the owner whether or not the business is on the right track. If not, then the statement helps identify non-performing areas needing attention for improvement.

What Is an Income Statement?

An income statement shows the profit or loss from a company's operations over a specific period. It takes revenues and subtracts expenses related to operations to arrive at a profit or loss.

What Is the Formula for the Income Statement?

Your accountant collects the entries from the company's journals and general ledger and separates them into revenue and expense categories. The formula for an income statement is as follows:

  • Sales
  • Less: Cost of Goods Sold
  • Equals: Gross Profit Margin
  • Less: General & Administrative Expenses
  • Less: Taxes
  • Equals: Profit Margin

For purposes of illustration, consider the following figures from the books of the Hasty Rabbit Corporation:

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  • Sales: $1,780,000
  • Direct Labor: $445,000
  • Direct Material: $623,000
  • Office salaries: $150,000
  • Rent: $225,000
  • Utilities: $110,000
  • Insurance: $50,000
  • Marketing: $40,000
  • Taxes: $55,000

Sales

The top line of an income statement, sales, is the first number to watch. A business must have enough sales to reach its breakeven point and make a profit. If not, the owner has to drive a more aggressive sales and marketing campaign.

Gross Profit Margin

The gross profit margin is a measure of the efficiency of its manufacturing operations. The gross profit margin for the Hasty Rabbit Corporation is calculated below:

  • Sales: $1,780,000
  • Less Cost of Direct Labor: $445,000
  • Less Cost of Materials: $623,000
  • Gross Profit Margin: $712,000

Gross Profit Margin/Sales X 100 = Gross Profit Percentage

$712,000/$1,780,000 X 100 = 40 percent

Is 40 percent an acceptable gross profit margin? Different industries have different acceptable gross profit margins that can be used for a guideline and comparison purposes. The owner of Hasty Rabbit Corporation needs to monitor this percentage to make sure that the manufacturing process is meeting production standards and working efficiently. Bottom line is the gross profit margin must be enough to cover the general and administrative expenses and leave a net profit.

Net Profit Margin

The net profit margin is the amount left after paying all expenses. The general and administrative expenses for the Hasty Rabbitt Corporation are as follows:

  • Office salaries: $150,000
  • Rent: $225,000
  • Utilities: $110,000
  • Insurance: $50,000
  • Marketing: $40,000
  • Total G&A expenses: $575,000

Gross Profit Margin - G&A Expenses = Net profit before taxes

$712,000 - $575,000 = $137,000

G&A Expenses/Sales X 100 = G&A Percentage

$575,000/$1,780,000 X 100 = 32.3 percent

Lastly, taxes are subtracted to arrive at the net profit after taxes

$137,000 - $55,000 = $82,000

Net Profit/Sales X 100 = Net Profit Percentage

$82,000/$1,780,000 X 100 = 4.6 percent Net Profit

Uses of an Income Statement

Owner and managers analyze income statements to spot trends in sales, gross profit margins, expenses and net profit margins. Presenting these figures as percentages of sales makes it easier to compare changes over months, quarters and annually.

What Are the Closing Entries in Accounting?

At the end of the year, the accountant will make entries to close out the temporary accounts for revenues and expenses. Typically, the closing profit or loss is made with an entry to retained earnings. Once this is done, the temporary accounts are reset with zero balances to start recording the activity for the next time period.

The example of the income statement for the Hasty Rabbit Corporation highlights three metrics to use as benchmarks of performance: gross profit margin, G&A expenses and net profit margin. Owners, managers and analysts have many other financial metrics to use when examining the profit performance of a business.

An income statement is one of the most important financial reports that an owner should use. After all, the objective of a business is to make a profit, and the income statement tells how well the management of a company is accomplishing that goal.

About the Author

James has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for blogs and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.

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