Each financial statement communicates specific information. Also, each financial statement is required in a particular context to understand a business’s financial health. One of the vital financial statements is the income statement. It details a business’s income and costs over a given period. An income statement carries a vast range of information for concerned parties, including employees, investors, stakeholders, and executives. Understanding how to prepare and read an income statement is vital.
Uses of the income statement
Several uses of an income statement are available. However, its primary purpose is to communicate the profitability and activities of a business. It offers micro-insights if created for a company’s departments. Depending on the income statement, investors and management can decide on the product, service, department, or the whole business’s strategy.
An annual statement provides an idea of the plan for next year. On the other hand, quarterly and monthly reports make it easier for a short-term strategy change. Important decisions like increasing production capacity, targeting new markets, pushing sales, opening or shutting down a department can be taken based on an income statement.
An income statement can be used by research analysts to compare a company’s year-on-year and quarter-on-quarter performance. Also, investors can be able to know if a company’s management has effectively managed to keep track of overhead operating costs without having to compromise productivity. Additional uses are:
- Income statements are vital for budgeting, financial forecasts, and strategic planning.
- Investors, lenders, and other partners use income statements to understand a business’s health.
- Income statements can be used to assess yearly tax filings.
Importance of an income statement
Income statements help entrepreneurs decide whether they can generate profits by decreasing costs, increasing revenues, or both. Also, it reflects the effectiveness of strategies that businesses set at the start of their financial periods.
Business owners or entrepreneurs can refer to this document to analyze their strategies and see if they have paid off. Depending on the outcomes of their analysis, they can identify or invent best practices and solutions to earn more profits. Additional things that income statements inform are:
- Frequent reports
- Pinpointing expenses
- Overall analysis of the company
What’s included in an income statement?
An income statement may vary slightly between different businesses since income and expenses depend on the type of business conducted and operations. However, several generic line items can be commonly seen in almost every income statement.
- Expenses: The amount of cash your business spent across the reporting period.
- Revenue: The amount of cash your business earned across the reporting period.
- Costs of goods or services sold: The total expenses associated with parts of any service or product a business makes and sells.
- Operating income: Operating expenses are deducted from gross profit.
- Gross profit: Costs of goods sold deducted from the revenue.
- Net income: Earnings before taxes.
- Income before taxes: Non-operating costs deducted from operating income.
- EBITDA: Income before interest, depreciation, taxes and amortization.
- Depreciation: Lost value by assets like property, equipment, and inventory over time.
- Earnings per share: Net earnings divided by the total outstanding shares.
How to prepare an income statement
Are you keen to prepare your first income statement? Let’s look at all the steps you need to go through.
- Pick your reporting period: A reporting period is the timeframe your income statement covers. Picking the right one is very important. Yearly, quarterly, and monthly reporting periods are standard. Your goals determine the reporting period you select, making it easier to implement tactical adjustments.
- Calculate the total revenue: The total revenue generated during your reporting period.
- Calculate the cost of sold goods: The total cost of products and services that generated revenue for your company during your reporting period.
- Calculate gross profit: Subtract the total cost of all goods sold from revenue for your reporting period to obtain gross profit.
- Calculate operating expenses: Operating costs are indirect expenses associated with doing business. They include legal fees, office supplies, overhead, utilities, rent, etc.
- Calculate income: Income is the pre-tax earnings your business earned during the reporting period. It’s also known as earnings before interest and taxes.
- Calculate interest and taxes: Interests are charges your business pays on the debts it owes. Factors that affect tax computation are payroll federal, state, and local taxes.
- Calculate net income: Your final step should be calculating the net income. Take your earnings before interest and taxes and then subtract interest plus taxes.
How to read an income statement
To read an income statement, you must first understand the analysis techniques available. They include vertical and horizontal analysis. The difference between these types is in how the readers read the statement and the comparison they can make from each analysis type.
- Vertical analysis: In this type of analysis, each line item is listed out of 100, or simply as a percentage. It means that line items on an income statement are stated in gross sales percentages instead of an exact amount.
- Horizontal analysis: This type focuses on every line item as a base figure percentage within a current reporting period. Horizontal analysis allows readers to review and compare changes in the currency amounts in a business’s financial statements across different reporting periods.
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