What Is an Income Statement?

An income statement is one of the most important forms of financial reporting. If you own or invest in a business, you need to be able to read and understand income statements.

What is an income statement?

An income statement is a summary of a company’s total sales, expenses and profits for a specific period of time. The time period it covers is typically a month, quarter or year.

Income statements are one of the three fundamental financial statements every business needs: the other two are the balance sheet and the cash flow statement. The income statement is the only one of these reports that shows sales, expenses and profits (i.e. sales minus expenses) or losses.

Sales, expense and profit or loss information is critical to tracking the performance of any business, large or small. A full financial package including an income statement is required when a business seeks to obtain outside financing, like a business loan.

An income statement is also sometimes referred to as a profit and loss statement, or P&L, because in accounting vocabulary, “income” means the same thing as “profit.” An income statement is also called a “Statement of Operations” because it presents the financial results of a business’s operations.

How is it used?

Income statements are used to analyze and identify improvements for a business. Some typical uses for income statements include:

• Trend analysis: Observing how revenues and expenses are growing or shrinking over time.
• Profitability analysis: Calculating how much profit is generated from every dollar of sales.
• Competitive analysis: Evaluating how the growth and profitability of one business compares to its competitors’ performance over the same period.

An easy way to understand what an income statement provides is to compare it to the two other main financial management reports:

What goes in an income statement?

Because income statements are widely used, they generally follow a consistent format that makes them simple to read. Here are the standard elements of an income statement, listed in the order they appear on the report:

• Sales (also called Revenues): The dollar value of the products and services sold during the period.
• Cost of Sales (also called Cost of Goods Sold, or COGS): The dollar value of the materials and labor used to produce what was sold.
• Gross profit: A subtotal that equals Sales minus Cost of Sales.
• Operating Expenses (also called Overhead): The administrative costs incurred by the business during the period, such as rent, insurance and management salaries.
• EBITDA (stands for Earnings Before Interest, Taxes, Depreciation and Amortization; also called Operating Profit): A subtotal that equals Gross Profit minus Operating Expenses.
• Depreciation and Amortization: Non-cash expenses calculated according to accounting rules to write off the value of equipment and other capital expenditures.
• Interest Expense: Interest paid on the company’s debts.
• Pretax Income (also called Profit Before Tax): A subtotal that equals EBITDA minus depreciation, amortization and interest expense.
• Income taxes: Taxes paid to federal, state and local governments on the income you make in a year.
• Net income (also called Net Profit, Profit After Tax or the “bottom line”): The total of Pretax Income minus Income Taxes.

How to create an income statement

Creating and using an income statement for your business requires three steps:

1. Choose a software package or template

A simple business with very few sales and expense transactions per year can use common spreadsheet software like Excel or Google Sheets and a basic template to create an income statement. There’s no need to buy an accounting software package to track the results of a lemonade stand!

On the other hand, if you’re juggling dozens or hundreds of sales and expense transactions per month, it’s best to invest in an accounting software package that automatically creates all the reports you need, once you input your data. This approach will save you time and avoid manual errors that often occur when using spreadsheets

The right accounting software will provide the functionality you need (inventory tracking, timesheet keeping, project management, etc.) at a cost that fits your budget.

2. Gather documents and input data

Your income statement is useful only if the data you’ve entered is complete and up to date. Best practices for ensuring this include:

• Set up a line on your spreadsheet template, or set up an account in your software package, for each sales or expense item you expect to have, like “online orders” or “rent expense”. Having this outline will help remind you where you may be missing data, like bills and receipts.
• Set up one file folder for sales receipts and another one for bills. Every time a document comes in, put it in its folder so you don’t lose it. If you’re receiving documents electronically, set up “folders” on your computer to put the electronic documents in as soon as you get them.
• Set aside a regular time every week for inputting what’s in the folders into your accounting system or template. After you’ve input the data from a document, put the document into a separate “entered” folder to avoid duplicate entries.

3. Format reports to help with analysis

For trend analysis, you will need to format your income statement so that two or more periods (like months or quarters) appear side by side on the same page. You also need to set up a column that calculates percent change from one period to the next. If you are using an accounting software package, it will offer a preformatted report that does this.

To do profitability analysis, you need a report that shows each line item on the income statement as a percentage of sales for the same period. Again, accounting software packages include this income statement format as a standard report you can select.

5 free income statement templates

As your business grows you’ll probably find yourself wanting to purchase accounting software to track transactions and create reports with ease and accuracy. But when you’re just getting started, you can set up a simple income statement yourself on a spreadsheet.

Here are five free income statement templates available to download and use:

• QuickBooks
• Microsoft
• Wise
• Sage
• SmartSheet

Example income statement

Here’s a simple single-step income statement example showing two periods for trend analysis. The Sales and Operating Expense lines can be expanded into several lines that provide more specific breakdowns about what’s in them if you need more details – this is known as a multi-step income statement. Multi-step income statements can be helpful if you’re looking to get a business loan or take on investors, who will want to see a more detailed breakdown of your finances.

Analyzing an income statement

Analyzing an income statement is the process of identifying positive trends to encourage, negative trends to fix, and competitive strengths and weaknesses to build on or improve. Here are some examples:

• Sales should show a continuous growth rate from period to period, except for temporary monthly fluctuations if your business is seasonal. Sales growth is always the goal.
• A sales growth rate that is higher than your competitors’ growth rates indicates you’re gaining market share and new customers.
• Gross profit should always be a positive number: this confirms your pricing is adequate to cover your costs.
• Operating expense growth should not exceed the sales growth rate over the long term, as this will erode your profitability and eventually create a loss.
• Your gross profit, EBITDA and net income as a percent of Sales should be equal to or greater than the same calculations for your competitors. If they’re not, see how you can improve yours by increasing your productivity or reducing costs.