It’s a simple truth: if you want to advance in your company, sooner or later you’ll have to understand your organization’s financials.
But never fear. In this post, we’ll break down one of the most important financial statements to any business: the income statement.
Why you need to understand financial statements
- Have better day-to-day conversations with your CFO
- Build a business case by demonstrating the financial implications
- Use financial statements to articulate and reach your organization’s goals
The income statement
(Also known as a P&L, earnings statement, statement of operation, statement of financial result)
What it is
An income statement shows whether your company operates at a profit or loss within a certain time period – hence why it’s often called a P&L, or profit and loss. The statement shows your organization’s revenue and expenses.
Why it matters
- Profitability. Income statements show how profitable a business is, and whether they’ve gained or lost profitability over time
- Competitive benchmarking: CFOs can compare their income statements to competitors, to gauge performance and see where they could be more efficient
- Operational insight: Income statements show CFOs how well managers use their budget (AKA how much they spend on salaries and raw materials)
The nitty-gritty details
Let’s take a look at income statements through the example of an ice cream shop.
Revenue, also called “top line” or net sales, is your sales. In this case, it’s how many cones, sundaes, sodas, etc. you sold in a given period.
Cost of goods sold, or COGS, is the money you pay to produce the goods you sell. In this case, ice cream tubs, toppings, lids, etc.
Gross profit – also called a profit margin – is simply your revenue minus your COGS. Keep in mind: Your profit margin could be huge, but you still need to factor in SG&A.
Which brings us to…
SG&A is the money you pay towards administrative expenses, including salary, rent, marketing, and benefits.
EBITDA is essentially everything you have before taxes, amortization and depreciation come in. In the case of this ice cream shop, we take our gross profit, subtract our SG&A, and come out with $15,000 in EBITDA.
If you’re a manager, you probably won’t have to worry much about the items below EBITDA in the income statement. But for complete understanding, let’s go over them.
Depreciation is the cost incurred by the deterioration of an item (in this case, a freezer) and amortization is the cost of long-term, fixed assets.
Operating profit is your EBITDA minus your depreciation and amortization.
Interest expense is the interest payable on any loans you have, and income expense is simply the taxes you owe each year.
Once you understand these various terms, a P&L is essentially a simple math problem.
Revenue - COGS = gross profit
Gross profit - operating expenses = EBITDA
EBITDA - depreciation and amortization = operating profit
Operating profit - interest and taxes = net income
Analyzing an income statement
There are two basic ways to analyze an income statement: vertical analysis and horizontal analysis (in other words, “reading up and down” and “reading side to side.”)
The goal of vertical analysis is to look at how your revenue and expenses compare to one another as a percentage of your top line.
In the example of our ice cream shop, we see that our net income lands at 24% of our top line revenue. On its own, that number isn’t terribly useful. That’s where competitive benchmarking comes in.
For example, we might look at our COGS (60% of revenue) and compare it to our competitors. If their COGS is only 40%, perhaps we need to find a new supplier for our cream or decrease our spending on fancy cups.
Horizontal analysis looks at your revenue and expenses over time – so compared to a different month, quarter, or year.
Doing a horizontal analysis helps us understand change over time. For example, in 2022, perhaps we increased the quality (and cost) of the cream we were using. We got an influx of new customers, but because costs went up and salaries increased post-pandemic, we ended up at a slightly lower net income.
Now, we might decide that’s acceptable because we’re scaling our business to a new audience. Either way, it’s good to keep an eye on these trends as a percentage of revenue.
Want to go deeper on income statements, as well as cash flow statements and balance sheets?
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