Every business owner needs to understand how to prepare an income statement. The preparation of financial statements details the specific income and expenses of a company over a specific period of time. Many stakeholders need these frequently to see how your business is performing, and not all of these stakeholders will be inside your company. Anyone from government officials to third-party service professionals to shareholders and stock owners might need them on a regular basis.
What Is an Income Statement
The income statement, also known as the profit and loss statement (P&L), summarizes your company's financial performance for a given reporting period, usually a month, quarter, or year. It outlines your company's revenues and expenses, ultimately revealing your net income or net loss.
Think of the income statement as a story of your company's financial activities. It tells you how much money you brought in (revenue), how much it cost you to generate that money (expenses), and what your profit or loss was after all is said and done.
Income Statement Applications
The income statement provides valuable insights into your company's financial performance.
Here are some key applications:
- Track performance and identify trends: Analyze income statements over multiple periods to identify patterns and trends in revenue, expenses, and profitability.
- This helps you understand your company's growth trajectory, and pinpoint areas of strength and weakness.
- Make informed business decisions: Use income statements to assess the effectiveness of your business strategies, and allocate resources.
- Attract investors: Income statements are a key component of financial reports used to attract investors and demonstrate your company's profitability and growth potential.
- File taxes: Income statements are a critical component of your tax filings, providing the basis for calculating your income taxes. Accurate and well-organized income statements ensure you are reporting your income and expenses correctly to tax authorities, minimizing your tax liability.
Main Components of an Income Statement
The income statement typically includes the following key elements:
Revenue
This represents the total income your company generated during the reporting period from all sources. It's the money your company earned from selling goods or services, and it's often the first line item on the income statement.
Types of revenue:
- Sales revenue: This is the primary revenue source for most businesses. It's generated from selling goods or services to customers.
- Interest income: This is the income earned from interest on investments, loans, or bank accounts.
- Rental income: This applies to businesses that own and rent out property, such as apartment buildings or office spaces.
- Royalties: This represents payments received for the use of intellectual property, such as patents, copyrights, or trademarks.
Cost of Goods Sold (COGS)
This refers to the direct costs associated with producing or acquiring the goods sold or the services rendered. These are the costs that are directly tied to the production or delivery of the goods or services your company sells.
Key components of COGS:
- Materials: The raw materials used to produce goods, such as wood, metal, or fabric.
- Direct labor: The wages paid to employees who are directly involved in the production of goods or services.
- Manufacturing overhead: Indirect costs related to production, such as factory rent, utilities, and machine maintenance.
Gross Profit
This is calculated by subtracting COGS from total revenue. It represents the profit earned before considering any operating expenses. The gross profit indicates how much money your company has left to cover its operating expenses and potentially generate a net profit.
Operating Expenses
These are the indirect costs incurred in running your business. They’re not directly related to producing or acquiring the goods or services your company sells.
Key categories of operating expenses:
- Administrative expenses: These include costs associated with managing the overall operations of the business, such as salaries, rent, utilities, insurance, legal and accounting fees, and office supplies.
- Marketing and advertising expenses: These include costs associated with promoting your products or services, such as advertising, public relations, marketing campaigns, and sales commissions.
- Research and development (R&D) expenses: This category applies to businesses engaged in innovation, research, and development of new products or technologies. It includes costs for research, development, and testing.
Operating Income
Calculated by subtracting total operating expenses from gross profit, this indicates your company's profitability from core business operations. Operating income shows how much profit your business generated from its core activities after covering the costs of producing and selling its goods or services.
Non-Operating Expenses
These are expenses incurred from activities not directly related to your core business operations.
Here are some examples:
- Interest expense: The cost of borrowing money, such as for loans or bonds.
- Loss from sale of assets: Losses incurred when selling assets, such as equipment or property.
- Tax expenses: The cost of federal, state, and local income taxes.
Pre-Tax Income
Also known as earnings before taxes, this represents your income before deducting income taxes. It measures your company's earnings before the impact of taxes.
Net Income
This is the bottom line, representing your profit (or loss) after deducting all expenses, including income taxes. It's the most important figure on the income statement as it reflects your company's overall profitability.
8 Steps to Prepare an Income Statement: A Practical Guide
Do you know how to do an income statement? Knowing how to prepare an income statement starts with knowing what goes on in income statements. The individual elements and calculations are all necessary.
Step 1. Choose a Reporting Period
It's essential that you pick the right reporting timeframe for your income statement. Common intervals include monthly, quarterly, or yearly. The one you should choose should reflect your specific goals. Monthly reports detail shorter periods so you can make tactical changes to your business the following month. Longer reports give you more of a high-level overview so you can see long-term trends.
Step 2. Generate a Trial Balance Report
If you want to know how to make a business income statement, then you need to print out a copy of your standard trial balance report. You should be able to generate a trial balance using your accounting software. These are internal documents that will list the end balance of every account in your general ledger for the designated reporting period. Coming up with these balance sheets is a vital component of making an income statement since they are how data from account balances are accounted for. This is necessary to come up with the end balance figures necessary for generating your total income statement.
Step 3. Calculate Total Revenue
You need to know how much revenue your company generated during the period of reporting that you have chosen. If your income statement represents the whole organization, then it needs to include revenue from every line of business. Alternatively, if you make an income statement for just one segment or business line, then you need to limit your revenue to services or products that actually fall under that purview.
Step 4. Determine the Cost of Goods Sold (COGS)
Costs of goods sold for all products and services generating revenue include distribution costs, components, parts, materials, and direct labor. These specific expenses must be directly related to making the things that make you money.
Step 5. Calculate Gross Profit
Subtract your COGS from your total revenue. Gross profit represents your margin on sales and reveals how much money you have left to cover your operating expenses.
Step 6. Include Operating Expenses
When you know what your gross profit is, you can then calculate your OPEX or operating expenses. These are usually indirect costs that are associated with doing general business. They're not the same as the cost of goods sold, as they aren't associated directly with the specific process of making or distributing your services or products. Specific examples that might fall under your operating expenses category might include legal fees, office supplies, overhead, utilities, and rent.
Step 7. Calculate Your Income
If you want to calculate the income for your business, just subtract your operating expenses from your gross profit. This basically becomes your company's pre-tax income that was generated throughout your designated reporting period. This is obviously one of the simplest calculations that you will do in the whole process, but it's also one of the most important numbers that you'll need from the report.
Step 8. Include Income Taxes
Once you calculate the income for your designated reporting period, you need to ascertain what your tax charges and interest are. Interest is simply charged as your business pays on owed debts. That means knowing how much you owe and what the specific interest rate in question is. You can automate this with the right accounting software. Your collective tax burden has to include local, payroll, state, and also federal taxes for the reporting period. This includes local, state, and federal taxes, as well as any payroll taxes.
Essential Tips for Creating and Using Income Statements
To effectively create and interpret income statements requires a combination of technical knowledge and practical skills.
Here are some key tips to help you optimize this important financial reporting process:
Choose Reliable Accounting Software
Utilize accounting software to automate the process of creating income statements to guarantee accuracy and efficiency. Many accounting software programs are available, such as QuickBooks, Xero, and Zoho Books.
Maintain Accurate Records
Keep meticulous records of all your income and expenses, using a clear and organized system. Good record-keeping is critical for accurate financial reporting, tax compliance, and informed decision-making.
Seek Professional Guidance
Consult with a qualified accountant or financial advisor to ensure your income statements are prepared correctly and used effectively.
At Lewis CPA, we provide the guidance and support you need to make informed decisions about your business.
Our team of experts can help you:
- Create accurate and insightful income statements.
- Understand and interpret your income statements.
- Develop a comprehensive financial strategy.
Prepare Your Income Statements with Lewis CPA!
Knowing how to prepare an income statement shouldn't just be left to accounting professionals. Anyone who learns this skill gains a deeper understanding of the financials of their business. Use an income statement to make near-future changes for shorter reporting periods or determine long-term strategy by looking at long-running trends. The professionals at Lewis.CPA can help you both generate income statements and learn all about the details they report. Contact us!
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