The income statement equation is frequently shortened to “Revenue – Expenses = Profit. That shortcut is helpful, but it conceals the number that is typically responsible for a business’s failure: the number where profit goes away. Sales may be increasing but, if costs of the product, payroll, rent, interest or taxes are taking a bite out of each profit dollar, a company can be making profits without a profit. The best way to do this is to determine the gross profit, operating income, pretax income and net income on their own.

The Income Statement Equation Has Several Layers

The equation that is used for basic accounting is income minus expenses equals net income. If the expenses are higher than the income, the net loss is the difference. An alternative approach breaks the calculation down into its components: Revenue – Cost of Goods Sold = Gross Profit; Gross Profit – Operating Expenses = Operating Income; and Operating Income + Other Income – Other Expenses – Taxes = Net Income.

Each subtotal contains answers to one of the questions. Gross profit indicates if the product/service is being sold at a price that covers its direct cost. Operating income is a measure to determine if the business has a profitable core business. Net income is the income after financing costs, non-operative costs and income taxes.

According to the SEC, an income statement (also known as a profit and loss statement) is one of the main financial statements that a company will produce. It measures income and the costs and expenses of generating that income in a specified time frame.

Start With Revenue, but Use the Right Revenue Number

Revenue is income generated from selling of goods or services during the reporting period. Does not always equal cash received. A consultancy can finish a job in March, but only receive £11,000 by the end of the month. If accural accounting is used, the full £18,000 can be recorded as March revenue, but the unpaid £7,000 will not be recorded as revenue until the job is finished.

Gross sales can be turned into net revenue due to returns, refunds, discounts or allowances. If a retailer records £120,000 of sales, £4,000 of returns, and £1,000 of customer discounts, net revenue is £115,000. The use of £120,000 in the profit equation would overestimate the performance by £5,000.

Maintain the same length of time. Avoid comparing expenses to three months of sales, or sales from one financial year to the next. A clear budget will help a small business to estimate the revenue and expenditure, but what the income statement should display is the actual revenue and expenditure during the specified period. If a company is looking to get a loan for a business, but has no sales history on its income statement, it will likely have to depend on the owner’s qualifications and forecasts.

Subtract Cost of Goods Sold to Find Gross Profit

Cost of goods sold, or COGS, is used by a business that sells products to refer to the costs that are directly associated with the products sold. That can be anything ranging from inventory purchases, raw materials, direct production labour, and freight to bring the goods in stock, depending on the business.

Gross profit formula is Net Revenue – Cost of Goods Sold = Gross Profit. A furniture shop has a net revenue of £115,000 and the furniture they sold cost £69,000 to them to buy or make, so the gross profit of the shop is £46,000. Its gross margin is £46,000 divided by £115,000, or 40%.

Gross profit is calculated by the businesses that are creating or purchasing goods and reselling them, after subtracting cost of goods sold from gross receipts, according to the IRS. It also separates the direct product costs from selling and administrative costs.

For service businesses, the COGS could be negligible or nonexistent. The gross profit of a freelance designer with no merchandise and £9,000 of net revenues can start around £9,000.

Deduct Operating Expenses to Calculate Operating Income

Operating expenses are the expenses associated with running the business but not part of COGS. Typical expenses include office rent, administrative payroll, marketing, business insurance, software, professional fees, utilities and depreciation.

In the case of a furniture shop, gross profit would be £46,000. The business has total wages of £14,000, rent costs of £7,000, advertising of £3,500, utilities and software of £2,000 and depreciation of £1,500. The total operating expenses are £28,000 and the operating income is £18,000.

Operating margin equals to operating income / net revenue. Here, £18,000 divided by £115,000 produces a 15.7% operating margin. If gross margin is still 40% and operating margin has decreased from 18% to 15.7% then overhead is increasing at a rate that’s higher than sales.

If a business is seeking a small business loan, they might be requested to provide income statements as this will help lenders determine if there is enough profit from a business to be able to make the repayments.

Account for Interest, Other Items, and Tax

The following step are the income and expenses not arising from ordinary activities. Interest on savings can be an additional income; interest on a loan can be a loss of profit. If the selling of old equipment provides a gain to the pretax income, it should not be confused with recurring sales.

Suppose the profit from operating the furniture shop is £18,000, its interest income is £300 and its loss on the equipment is £900, while the loan interest it paid is £2,400. Pretax income is £15,000: £18,000 plus £300, minus £2,400 and £900.

If income tax expense is £3,000, net income is £12,000. Net margin equals £12,000 divided by £115,000, or about 10.4%. The business retains £0.10 in each £1 of net revenue as an accounting profit.

The interest expense will be based on the balance, interest rate and terms of the loan. Knowing how compound interest works can assist a business owner realize that financing costs can increase even if sales are constant.

Work Through a Complete Income Statement Example

Let’s take a small online retailer who sells £250,000 but returns £8,000 and offers £2,000 in discounts. Net revenue is £240,000. COGS is £138,000, so gross profit is £102,000 and gross margin is 42.5%.

The retailer then enters £35,000 in wages, £12,000 in warehouse rent, £9,000 in marketing, £6,000 in software and professional fees, £5,000 in shipping that was not part of COGS and £3,000 in depreciation. The operating expenses are £70,000 and operating income is £32,000.

Pretax income is £29,000 after deducting the interest expense of £4,000 and the other income of £1,000. Tax expense of £5,800 leaves net income of £23,200. The net margin is about 9.7%.

This is a stacked calculation to indicate where the funds came from. The company did not simply earn £23,200 from £250,000 of sales. That left £10 000 of less in revenue, £138 000 in product costs, £70 000 in operating costs, and £8 800 in interest and tax costs.

Profit Is Not the Same as Cash Flow

Net income may increase even though the bank account decreases. A company can take on sales without cash received from customers, have sales orders placed in advance, have inventory items sold and not yet paid for, make payments on loans, or buy equipment. These transactions have an impact on cash that differs from accounting profit.

If the retailer has £23,200 net income and the customers still owe £30,000, what would be the customer’s net income?If the retailer reports £23,200 of net income but customers still owe £30,000, what is the net income of the customers? It also purchases additional equipment which costs £12,000 and pays back £6,000 of loan principal. The business can be profitable, but have a cash shortage.

On the other hand, deposits may be taken before the business receives the revenue. Cash comes before the income statement, but income is recognised after cash. This is why it is important for the owner to analyze the income statement along with the balance sheet and cash flow statement and not as “spendable cash.

Business credit can indeed be a problem when it comes to borrowing in a cash shortfall, but borrowing isn’t a cure for low margins. Determine if it is a slow collection, too much inventory, too much overhead, or not a very profitable product.

The Bottom Line

Find profit in layers, not from revenue to net income. Beginning with Net Revenue, deduct COGS, then operating expenses, interest, other items, and taxes. Analyze gross, operating and net margins over the periods to identify gain or loss points. Then, create a basic monthly income statement using sales data, bank statements, and your invoices, payroll, and receipts, and then explore any expense that is increasing at a rate more than your sales.

Frequently Asked Questions

What is the basic accounting equation of the income statement?

The formula for basic equation is: Revenue – Expenses = Net Income. A detailed income statement breaks down COGS, operating expenses, interest, other items and taxes to allow you to see how each layer impacts your bottom line.

What is gross profit on an income statement?

Subtract COGS from Net revenue. If net revenue is £80,000 and COGS is £48,000, gross profit is £32,000 and gross margin is 40%.

What is the difference between operating income and net income?

Operating income is the profit from the business before interest, taxes and other non-core activities. When those items are taken into account, Net income is the last profit or loss.

Discamiler:

This article is for general informational purposes only and does not constitute financial advice. Please consult a qualified financial adviser for guidance specific to your situation.