Ever wondered how businesses calculate their profit at the end of each year? The simple answer is the “Income Statement.”
Every business drafts an income statement to calculate profit or loss for the year.
Have you never made one? Don’t worry, that’s why I’m here today. I will discuss the income statement in detail, and by the end of this blog, you will understand it fully.
Here’s what we will be discussing today:
- What Is an Income Statement?
- The Example Of Income Statement.
- The Types Of Income Statement.
- What Is A Pro Forma Income Statement?
What Is An Income Statement?
The income statement is classified as one of the crucial financial statements of a company. The statement is drafted by the finance department to determine the profit or loss for the given period (usually a year).
The profit or loss is calculated by subtracting all operating expenses from the gross profit. Here’s the simple equation that you can use to do so:
Gross Profit – Operating Expenses = Net Profit
To add to your knowledge, the formula to calculate gross profit is:
Sales – Cost Of Goods Sold = Gross Profit
However, you might’ve noticed that the values aren’t calculated in a single line; in fact, you need to prepare a statement that mentions everything.
If you ever hear anyone say “net income statement,” “statement of earnings,” or “profit and loss statement,” then they’re referring to the income statement.
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How To Make An Income Statement?
To help you understand better, here’s a hypothetical income statement example.
For someone with a non-accounting background, the income statement might feel a little intimidating, and that’s why I’m going to explain each particular in detail.
The sales revenue value is the total sales you’ve made during the year. The figure can be from anywhere between a day and up to a year – depending on how you calculate sales.
In our example, the sales revenue is calculated for a whole year.
Cost Of Goods Sold
The cost of goods sold is the cost incurred while producing the goods or the services you offered to your customers.
The COGS include all expenses related to raw material, labor costs, shipping fees, and other production costs.
For example, a clothing brand’s COGS would include the cloth material, labor used to stitch the dress, the shipping fee incurred to import the cloth material, and the shipping fee incurred to send the dress to the boutique.
Basically, all direct costs involved in the production process are COGS.
The indirect costs like employee salaries, rent, utilities are not included in the COGS.
Gross profit is the value you get when you subtract sales from your cost of goods sold.
The gross profit value tells you how much direct profit you have from selling your goods; however, it’s not the final amount; you still have to deduct operating expenses before you can get to the final net profit.
Operating expenses are any expenses that incur outside of the production unit. It includes rent, depreciation, marketing and advertisement expenses, employee salaries, payroll, interest expense, pensions (unemployment benefits), etc.
Some businesses prefer making a simple income statement and combine all the operating expenses, while others prefer to list each expense separately.
Both ways are correct; it’s just a matter of preference.
Net profit is the actual profit (or loss) you earn after deducting all the costs and expenses. This is the profit amount that also comes under the owner’s equity in the balance sheet, and yes, you can enjoy it (or invest it).
The Types Of Income Statements
As displayed, the income statement format is quite simple and easy to follow. Any business can follow it as long as they know how to differentiate between the costs of production and operating expenses.
Apart from the regular income statement, some businesses prefer to draft two other types of statements.
A Single-Step Income Statement
The single-step income statement is a more direct approach to drafting an income statement. In such statements, all the revenues are calculated and subtracted from direct costs, and then further deducted from operating expenses to get the net profit/loss.
Here’s a hypothetical example:
As the snippet shows above, the single-step income statement is drafted to analyze if the company had a profitable year or not.
Even though it does the same job, it’s not as widely used as the multi-step income statement.
Common Size Income Statement
The common size income statements are exactly like the multi-step income statement, but the only difference is that they have an extra column that shows the percentage.
To elaborate, it shows the percentage of each item of your total revenue.
A little confusing? Here’s a small example.
Notice that extra column on the extreme right? That’s the percentage of revenue for each line in the income statement.
Some businesses prefer to make common size income statements to see what contributes most to their net profit or loss. It helps to pinpoint the component affecting the financial position.
What Is A Pro Forma Income Statement?
Another term you should learn about is the “pro forma financial statements.” It might sound complicated, but in simpler terms, it refers to the statements that are drafted based on assumptions and projections by the finance department.
The statements help businesses prepare for what’s to come and test different solutions to either avoid a loss or achieve the profit as suggested by a pro forma financial statement.
A pro forma financial statement looks like a regular multi-step income statement except that it’s “calculated” for 1-2 years in advance.
There are four types of pro forma financial statements:
- A full-year statement refers to the calculations from the present up to a year.
- A financing or investment pro forma projection to understand how investments will affect your business.
- A historical pro forma financial statement that reflects on your business’s past statements to help predict the future.
- A risk analysis pro forma financial statement shows the best and worst-case scenarios to anticipate your business’s future.
I hope the guide helped you learn everything about the income statement.
For more information related to accounting subjects like balance sheet, account receivables, owner’s equity, or depreciation methods. Read more of our guides.