A business owner’s income statement is a key part of their financial story. You might be tempted to leave as much of your accounting work up to your bookkeeper, sure. But your income statement — which you also might know as your Profit & Loss, P&L, or earnings statement — is something you should know how to read (and produce) own your own.
A P&L gives small-to-medium enterprises (SMEs) the crucial understanding of the actual net profit of their business. In other words, it’s the only way you can actually figure out if your company is making money — and whether you might want to adjust your cash flow management processes to get yourself to profitability.
The basics of an income statement
With accounting, it’s tempting to stuff your fingers in your ears and leave everything to your certified professional accountant (CPA). At Smansha, we’re fundamental believers that it’s really important to know what’s going on in your books so you don’t have to smile and nod as if you understood your own business’s financials.
In the simplest sense, an income statement measures your income and expenses over a period of time. (Hence why it’s also called a Profit & Loss — these terms are interchangeable with “income statement” from here on out.) You’ll quite obviously want to keep P&Ls for your fiscal year, but most SMEs also keep these for quarters to spot helpful cash flow patterns (we’ll talk about this more in a bit, hang tight). Sometimes, producing them monthly can even help more.
Whether or not you’re tracking these numbers formally, you’re likely keeping tabs on this info in some sense or another. Otherwise, you’d have no idea what’s exactly going on in your business. But the point of an income statement is to get stuff organized in one place for you to be able to make informed decisions and help anyone else who’s evaluating your financials (like a business lender or the IRS, for instance) get a quick sense of the financial health of your company.
If you’re using small business accounting software, like QuickBooks Online, you can create an income statement within the application. At Smansha, our cash flow forecasting and risk assessment tool uses your income statement as a primary source for analysis and insights.
What an income statement shows
When someone’s on a diet, they’re supposed to log calories in and calories out. It makes sense why a dietitian would recommend a food and exercise journal — if you’re trying to get a sense of whether or not you’re on the right path to losing weight, you have to understand whether you’re eating more or burning more. Your net calories will tell you.
In a way, your statement of income is like your business’s diet plan. You have to figure out if you’re spending or earning more, and your net profit will reveal that. Spend more than you earn and you’re in the red; flip that, and you’re in the black.
The numbers on your P&L will allow you to get a sense of the answers to these questions:
- Is my business generating a profit?
- Am I spending more than I’m earning?
- When am I spending the most, and when are my costs lowest?
- Am I paying too much to produce my product?
- Do I have money to invest back into my business?
And, the more granular your records, the better able you’ll be to identify trends.
What you’ll need to read an income statement
There are a few essential elements of a Profit & Loss. You’ll need to understand the fundamental differences among them all to not only put one together but to also read one, too.
The first two are the most important of all:
- Revenue: What your business takes in. This combines any revenue stream, whether it’s from a retail storefront, e-commerce, wholesale business, passive investments — you name it. Put that here.
- Expenses: What your business spends. This includes both the fixed and variable costs for making your company run on a daily basis. Think salary, overhead, redesigning your company website, software.
Then, you’ll also want to know:
- COGS: Cost of goods sold. This means taking into account the component parts of what it takes to make whatever it is you sell. So, even if the candles in your shop sell for $18, you need to think about the expenses to get the goods ready for sale, like the jars, wicks, wax, and labels. This is most important for product businesses, less so for service businesses who may not have a COGS.
- Profit: Your total expenses minus your total revenue. Although this seems straightforward, this doesn’t tell the whole story.
- Gross Profit: Your total profit minus COGS. You end up paying your business’s operating expenses from your gross profit, so this number is arguably the most important of all to understand from your income statement.
You might also hear the abbreviation EBIDTA, which means “earnings before interest, depreciation, taxes, and amortization.” Don’t worry about that too much unless you’re dealing with investors or you’re a very high-grossing business (in which case, your accountant will help you out). But, basically, this number provides a very clear picture of how your business is doing without these other factors. A look at the cold, hard financials of your business beyond cash flow, since it looks at non-cash items, too.
Your income statement will include some other terms, too, but these are the ones you’ll need to grasp in order to use a P&L effectively to make decisions for your business.
Who looks at your income statement
Some or all of the following parties will or should review your P&L statement:
- The Internal Revenue Service (IRS). You might need to prepare your Profit & Loss for any number of reasons. In the most basic sense, the IRS will generally need to take a peek at your income statement — along with your balance sheet and cash flow statement — in order to verify your business’s financials. If for no other reason, that should give you a big incentive to keep this important document clean and up to date. Also, your business income taxes are based on your profit each year.
- Small business lenders. In many scenarios, lenders require you to submit your income statement with your application for business financing. That especially goes with term loans where lenders will be taking a hard look at whether or not you can handle your repayment.
- Investors. Unsurprisingly, if you’re courting investors — or vice versa — submitting a Profit & Loss in due diligence will be a must. In order for lenders to get a true understanding of your financial picture, they’ll take a hard look at your books. This is where EBITDA on your statement of income will be important, as well as your cash flow forecasts. Detailed records are essential here.
- Buyers or clients. If you’re planning on selling your business — or even doing business with new clients — you should prepare to have your P&L ready to show. The income statement gives partners a sense that you’re solvent.
- You. (No exceptions on this one.)As a savvy business owner, the more time you spend in the weeds understanding where you’re spending and where you’re earning, the more intelligently you can make decisions. The more helpful you find your P&Ls, the more you might find you want to keep more frequent records.
Your income statement should inform financial decisions
Your Profit & Loss is meant to give you a great sense of the current sense of your business financials. Beyond seeing the now, though, smart business owners will make decisions based on the numbers.
The relationship between cash flow and your P&L
First, your income statement will part the clouds about your net profit. Should you be looking into different manufacturers or suppliers to lower your cost of goods and spending less? Should you be shifting a portion of your production to a different season to even out your cash flow?
Toward that end, you’ll also be able to spot important seasonal fluctuations in your finances. Even if you’re not making tweaks to your cash flow management processes based on this info, it’s essential that you know the trends.
Tools, like cash flow forecasting (see image below), also help you better understand how your business both earns and spends throughout the course of a month, quarter, and year. These kinds of insights and analysis are powerful. You’ll really know when your business will be flush with liquidity, and when you need to save up.
The information in this article is not financial advice and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
Images via Pexels and Shutterstock.