What Exactly Is Your Income Statement Telling You?

We often find that small businesses owners don’t fully understand how to read their financial statements. Our six tips will help owners understand what this document (called a profit and loss, or P&L, statement) is trying to tell you and how to use it to make management decisions.

Each three-page statement was neatly stapled in the upper left corner and three-hole punched, with no crease by the staple– and no indication that the owner had even looked at the second page.

Immediately, we knew that the client did not use those financials to help her run her business.

1. Income statements cover a period of time.
The income statement reveals how much money your business made over a period of time. Most often, the statement reflects performance over a year, a month or a quarter. You’ll also see year-to-date income statements that reflect activity from January 1 through the current date (usually the end of a month).

You might see “Y-T-D August,” indicating the period for January 1 to August 31. The important point is that income statements always cover a period of time and that it is essential to note that time frame.

2. Every income statement follows a simple formula.
Every income statement, no matter how complex, follows a very simple formula: Revenue – Expenses = Profit

It really is that simple. For whatever period the income statement covers, it shows the revenue the business earned, the expenses it incurred and the profit it made.

3. Multiple names for one item cause complexity.
One thing that can make income statements seem more complex is that people use different names to refer to the same thing. The term “sales” or “income” might be used instead of revenue.

Just don’t let the jargon throw you. Remember, no matter what terms you use, the money that comes in minus the money you paid out equals the money you get to keep.

Related: 5 Things Not to Do Running a Small Business

4. Expenses are often split into multiple parts.
Another thing that can make an income statement seem more complex than it is, is that expenses are usually broken down into components, and profit is calculated at interim levels. You will often see:

COGS are those costs related directly to the products or services that you sold. The material you bought to make the widget you sold and the compensation you paid to the widget-builder would be included in COGS. COGS generally vary directly with revenue, which is a function of the number of widgets sold.

SG&A are those costs which, while necessary, are not related directly to the number of widgets sold. The salary of the president, the CFO and the salespeople are typically included in SG&A as are the utility and the rent bills for the office building. These costs are typically more constant month to month and don’t vary with the number of widgets sold.

Revenue
Cost of goods sold
Gross margin
Selling, administrative and general
Profit
In this case, expenses have been broken down into two parts: cost of goods sold (COGS) and selling, administrative and general (SG&A).

5. Gross margin percent should be relatively constant.
With expenses split into two parts, profit is calculated at an interim level called the gross margin. The gross margin (also called gross profit), is the money you receive from the products (or services) you sell, less what it cost you to deliver them.

Gross margin percentage = gross margin/revenue

The reason this is valuable is that, as explained above, COGS should move with revenue. The gross margin percentage should be relatively constant.

6. Dollars spent on SG&A should be relatively constant.

The income statement reveals how much money your business made over a period of time. You’ll also see year-to-date income statements that reflect activity from January 1 through the current date (usually the end of a month).

One final thing to keep an eye on are the dollars you are spending for SG&A. This number should also be reasonably constant from period to period. A significant change in the dollars you are spending on SG&A should also be a red flag that causes you to dig a bit deeper to understand what is happening in your business.

One thing that can make income statements seem more complex is that people use different names to refer to the same thing.

We often find that small businesses owners don’t fully understand how to read their financial statements. Our six tips will help owners understand what this document (called a profit and loss, or P&L, statement) is trying to tell you and how to use it to make management decisions.

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