Understanding Financial Statements: The Income Statement
There are two basic financial statements: the Balance Sheet and the Income Statement.
The daily operations of a business are measured in the money that comes in as revenues, the money that goes out as expenses, the money that is retained as profit, the money that is invested in operational assets, and the money that is owed. It’s all about the money. Financial statements follow the money.
The report that measures these daily operations, of money in and money out over a period of time, is the Income Statement.
Revenues minus Expenses equals Net Income
The Income Statement can be summarized as: Revenues less Expenses equals Net Income. The term Net Income simply means Income (Revenues) net (less) of Expenses. Net Income is also called Profit or Earnings. The terms “profits,” “earnings” and “net income” all mean the same thing and are used interchangeably. They are synonyms for the bottom line number on the Income Statement. Revenues are often called Sales and are represented on the top line.
You understand the dynamics of this concept intuitively. We always strive to sell things for more than they cost us to make or buy. When you buy a house you hope that it will appreciate in value so you can sell it in the future for more than you paid for it. It’s also the rule for stocks: buy low, sell high. In order to have a sustainable business model in the long run, the same logic applies. You can’t sell things for less than they cost to make and stay in business for long. If you own run a sandwich shop you had better make sure that you are selling the sandwiches for more than they cost you to make.
Think of the Income Statement in relation to your monthly personal finances. You have your monthly revenues: in most cases the salary from your job. You apply that monthly income to your monthly expenses: rent or mortgage, car loan, food, gas, utilities, clothes, phone, entertainment, etc. Our goal is to have our expenses be less than our income.
There is an old adage: “If you outflow is more than your income, your upkeep is your downfall.”
Over time, and with experience, we become better managers of our personal finances and begin to realize that we shouldn’t spend more that we make. We strive to have some money left over at the end of the month that we can set aside and save. In business, what is set aside and saved is called Retained Earnings.
Some of what we set aside we may invest with an eye toward future benefits. We may invest in stocks and bonds or mutual funds, or we may invest in education to expand our future earning and career prospects. This is the same type of money management discipline that is applied in business. It’s just a matter of scale. In business we buy assets that help the enterprise expand or perform more efficiently. There are a few additional zeros after the numbers on a large company’s Income Statement but the idea is the same.
This concept applies to all businesses. Revenues are usually from Sales of products or services. Expenses are what you spend to support those sales in terms of the operations: Salaries, raw materials, manufacturing processes and equipment, offices and factories, consultants, lawyers, advertising, shipping, utilities etc. What is left over is the Net Income or Profit. Again: Revenues – Expenses = Net Income.
Net income is either saved in order to smooth out future operations and deal with unforeseen events (save for a rainy day); or invested in new facilities, equipment, and technology. Or part of the profits can be paid out to the company owners, called shareholders or stockholders, as a dividend.
The Income Statement is also known as the “profit and loss statement”. Business people sometimes use the shorthand term “P&L,” which stands for profit and loss statement. A manager is said to have “P&L responsibilities” if they run an autonomous division where they make the decisions about marketing, sales, staffing, products, expenses, and strategy. P & L responsibility is one of the most important responsibilities of any executive position and involves monitoring the net income after expenses for a department or entire organization, with direct influence on how company resources are allocated and responsibility for performance.
Google the term “income statement” and you will see lots of examples of formats and presentations. You will see there is variety depending on the industry and nature of the business but they all follow the basic principles outlined in this post.
Remember: Income (revenue or sales) – Expenses = Net Income or profit
If you are interested in a deeper dive on these concepts check out my books Learn Accounting Fast! and Reading and Understanding Financial Statements.
