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What is income statement and its purpose? – Reports Part 2

profit and loss statement

An income statement, also known as a Profit and Loss (P&L) statement, is a financial report that summarizes a company’s sales and expenses over a given period, the most common periods will be monthly, quarterly, and annually. The Income statement can evaluate a company’s financial performance and provide insight into its operating costs and revenue streams. Income statements typically include several key elements, such as total sales, net income, and cost of goods sold. Tracking these figures over time allows businesses to identify trends and make informed decisions about pricing, expenses, and other strategic initiatives. Shareholders and creditors can also use income statements to assess a company’s financial health.

Correct Structure of the Income Statement

The Income statement is divided up into four sections:

 

  • Sales
  • Cost of Goods Sold
  • Operating Expenses
  • Other Income and Expenses

 

But what about service industries? You might be in the plumber or contractor business, thinking that since you don’t have physical goods to sell, your revenue and expenses statements will look very different from other businesses. However, this isn’t true! Think of all those direct costs that you incur to provide the service. These costs could be material and labor, to name a few.

In reality, you have costs of goods sold, but not in the sense you see. When dealing with the service industry, you are right, we don’t talk about the cost of goods sold, but we do speak about direct costs.

So why is it important to calculate your cost of goods sold or direct costs?

You get your gross profit when you deduct the cost of goods sold from your revenue. The next step is to divide your gross profit with your income. Multiplied by 100 gives you a percentage which we refer to as your gross profit margin.

Here is an example: Your gross sales are $100,000.00, and your cost of goods sold or direct expenses equal $80,000.00. Using the formula from the previous paragraph, we can calculate that your gross profit is $20,000.00. Take this a step further, and you can calculate your gross profit margin, which is $20,000.00/$100,000.00 X 100 = 20%.

Use this number to compare yourself against industry standards or other businesses directly. But John, I just started my business. I can’t compare myself to big multi-million dollar companies. This is precisely what you can do and should. If the industry standard is 25% and your GP margin is 20%, you know you are below what running a healthy business in your industry should be. In another blog, I will break down the different uses of GP margin.

What about the rest of the expenses?

The rest of the expenses are classified as operational and other expenses. More about the additional costs later. Let’s look at the operational expenses first.

Operational expenses are all the other expenses, like marketing, management wages, office wages, telephones, repairs, maintenance, and the list goes on. You will list these expenses and then deduct their total from your gross profit. Once you have done this, you will arrive at an EBITDA (Earnings before interest, taxes, depreciation, and Amortization).

Why would you like to know this number? Well, one of the reasons is that we use EBITDA to calculate what your business is worth.

I need to point out that EBITDA alone doesn’t give you the value of a business. It’s a bit more complex than that, as we use EBITDA and multiply it with a factor, then use other calculations to arrive at the total value of the business. But EBITDA is one of the starting points.

John, you said there are other expenses. What is happening to them?

If you haven’t guessed it from reading the previous paragraph, other expenses include line items such as Interest, Income Taxes, Depreciation, and Amortization.

After deducting the other expense, you arrive at your net profit. Again, this calculates your net profit margin by dividing the net profit by the gross sales.

Use your net profit margin to compare your business against other businesses. The average profit margin for a small business is around 10%. This may be higher or lower depending on the industry and type of company, but in general, you can expect your healthy profits to range between 7% – 15%.

This section will also include interest income. I was going to write about depreciation here, but as I write, I figured it best to devote a separate post to it. 

Conclusion:

I hope you have found the article helpful. Let me know what you think by leaving a message in the comment section. If your Income statement doesn’t look like the one I described, or if you are unsure, don’t hesitate to contact me for a free consultation.

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