How To Read An Income Statement

Have you ever looked at one of the reports your bookkeeper sent you and...actually, let's stop that thought there. For many freelancers, solopreneurs, or small business owners, that's about as far as you get. You're sent some type of financial statement that seems important, but you aren't given any instruction or guidance on how to read it.

There may be valuable data in there that could help you improve your company's financial performance, but it's hard to figure out where to start and what to focus on. So instead, you toss it into a folder and forget about it.

This post is part of a series on financial literacy. In particular, I want to direct these to the business owners who are trying to do it all yourselves.

Whether you are doing your own bookkeeping or getting your financial data from a professional bookkeeper, I want you to be able to read and understand the financial statements you see each month. In addition to the income statement, some of the other financial statements I plan to cover are:

• Balance sheet
• Cash flow statement
• Accounts Receivable & Accounts Payable
• and more

How to read an income statement

Before I get into the details, here are a few quick tips about reading an income statement.

• Actually read the income statement each month.
• Don't just skip to the bottom line to see your net profit.
• Reading it is not a one-way trip. Jump between sections to ensure you understand what the income statements are telling you.
• Prepare a list of "why" questions to ask yourself or your bookkeeper when you're done.
• Remember that the income statement is not the full picture. Reading and understanding it, along with other reports like the balance sheet and cash flow statement, will give you a better understanding of how your small business is performing.
• The layouts may vary slightly. Certain industries might categorize things differently than what I discuss below.

Cash Basis vs Accrual Basis

There are two ways you will report income and expenses; either on a cash or accrual basis.

Cash basis: The revenue or expense is recorded when cash is received or paid out.
Accrual basis: The revenue is recorded when it is earned and the expense is recorded when it is used or incurred.

For example, let's say you perform some design work for a client in June. You send them an invoice on July 1st and get paid on July 10th.

With cash basis accounting, you'd record the revenue in July when you get paid. With accrual basis you'd record the revenue when it was performed in June.

Income Statement vs Profit and Loss Statement

Depending on where you live, this report may be called a profit and loss statement. In Canada, where I'm located, that's what we call these reports. They are interchangeable terms.

Alright, let's get started.

Read income statements from top to bottom...first.

Even if you don't understand income statements yet, they are laid out in a very simple way. There are even visual breaks to identify the different sections. You are going to start at the top of the report and work your way down through each section I will describe below.

One big difference between an income statement and a balance sheet is the accounting period.

A balance sheet is a snapshot of a specific date. It tells you how much __ you had in the business as of yesterday, last month, or last year.

An income statement tells you how much things have changed during a period of time. That's why you will see a range of dates at the top of your income statements. It's a description of how __ changed between two dates. How much more revenue is generated, or how many more expenses incurred.

Note: every accounting software does this a bit differently, so sometimes you'll just see "for the year ending 12/31/2023" instead of the full range.

Revenue (or Income)

The first section of an income statement is dedicated to your company's revenue. Once again, some software calls this revenue, and others call it income. I think there's a difference, but what do I know? In this section, you may see a few different items listed.

• Sales
• Fees
• Services
• Commissions

Depending on how you, your bookkeeper, or your accountant have set up your Chart of Accounts, this may be one line like this,

or several lines like this.

Tip: I think you should have at least two revenue categories unless you only ever have money coming in from one activity. If 99% of your revenue came from web design or selling products on Etsy, but 1% came from affiliate marketing on your website, I think you should track these separately. Don't go crazy. If you sell ten different types of handbags don't create ten revenue categories. You can run a separate sales report to find out how well each product sold. Even an "Other Revenue" category is fine to cover the parts that aren't at the core of your small business.

The goal is to understand how you're generating your total revenue from your various income streams.

If you see "total revenue" is up 20% compared to last year, that tells the story that your business is growing.

If you see "Consulting Revenue" is down 5% but "Other Revenue" is up 20%, that tells the story that your business is changing.

Discounts and write-offs.

The revenue section is also where you might see negative amounts. If you offer your customers a discount and you track those discounts, they will show up here and will reduce your total revenue. If you have to write off a sale because the customer wasn't happy, it's best to include that sale in revenue and then offset it with a negative amount as a write-off.

Once again, it's about telling a story to better understand your business.

Selling $100,000 tells a different story than selling $125,000 and having to write off $25,000 of that because of poor quality.

All of this will give you your total revenue. This is an important number but means nothing without the context of the next sections. This is where you will hear people brag that they are a 10 million-dollar company. Many of them will neglect to mention that they spent 11 million dollars to get there and are struggling to keep the lights on.

Cost of Goods Sold (or Cost of Sales)

Depending on the software, your bookkeeper, or your accountant, you might see one of these terms. I try to use cost of goods sold when you're selling a product and cost of sales when you sell services. The broad categories that will show up here are the following:

• Direct Materials
• Direct Labour Costs
• Manufacturing Overhead
• Production Supplies

These are all costs that are directly tied to the products and services that you sell. These are specific to your business and not to the product or service itself. For example, if you run an office cleaning business, your cleaning supplies are direct costs. If you run a food truck, they are operating expenses.

The same goes for labour costs. If you run a bookkeeping practice, your bookkeepers are direct costs. If you run a social media consulting firm, they are administrative expenses.

If you sell a product, this is where you will track the cost of the materials and manufacturing in order to produce that product. This could be the leather you use to make the wallets you sell or the amount you paid for the vintage stereo you restored and flipped on eBay. It also includes the supplies you buy for the production equipment. If you sell stickers, the sticker paper is a cost of goods sold, but the paper you use to print out the income statement is an operating expense.

Since we're tracking costs directly associated with revenue, I also include merchant fees here. The 2.9% you pay to Stripe or PayPal for each sale wouldn't have happened without the sale. The $30/m you pay to maintain your bank account, however, happens regardless of how many sales you make, so I like to separate those two sets of bank fees.

Tip: You don't have to lump an employee into one section. If you have a web developer that spends 75% of their time on client work and 25% of their time maintaining the company's website, split it up. Allocate 75% of their wages (taxes, benefits, etc.) to cost of sales and the other 25% to indirect labour.

Once again, the income statement is telling the story of your business. Let's break down the example to show what I mean.

Scenario #1: You count 100% of your developer's time to cost of sales. You notice your gross profit (see below) is low, which could be an indication that your prices are too low.

Scenario #2: You discover 50% of your developer's time is spent on client work and split it up accordingly. Your gross profit looks better, so your prices aren't the problem. You might have a different problem.

• You don't have enough client work to keep your developer busy, aka you're overstaffed.
• You are giving them too much non-billable work which keeps them from generating more revenue.

Gross Profit

You can also see this listed as gross revenue or gross income. The formula is:

Revenue - Cost of Goods Sold = Gross Profit

It's expressed as a dollar amount. You will usually see this accompanied by gross margin or gross profit margin. The formula is:

Gross Profit divided by Revenue = Gross Profit Margin

This is expressed as a percentage.

What is gross profit?

Gross profit is an indication of how efficiently you produce the product or service that you sell.

This is why it's so important to properly categorize your expenses. Knowing where your business is succeeding or struggling gives you the knowledge you need to make better decision going forward.

What's a "good" gross profit margin?

This will vary wildly based on your industry. A big retailer like Costco has gross profit margins that are consistently between 12-13%. If you sell digital goods online, you could see gross margins above 90%. In my experience, if you run a service-based industry, 60% is a decent benchmark.

My advice is to do some research on your industry. The industry standard is just a guideline. You may find you're only hitting 50% as you ramp up the business and offer lower prices to acquire new customers. As with every section in the income statements, the trends over time are more important than any single reporting period.

Operating Expenses

You may also see this referred to as overhead expenses. In most cases, this will be the longest section of the income statement. There are two main reasons for this.

There are a lot of different types of expenses here, and you'll want to track them separately in order to make better business decisions.

These categories need to be reported separately on tax returns. The list of operating expenses is often created to align with what your accountant will be tracking on your tax return.

Types of operating expenses.

The list you'll see in your accounting software may differ, but here's a list of the typical categories of operating expenses.

• Bank fees and interest expenses
• Advertising and marketing
• Insurance
• Office supplies
• Depreciation expenses
• Rent and utilities
• Indirect Labour costs (any wages not directly tied to the product or service, such as the bookkeeper or the receptionist)
• Professional fees (fees you pay to contractors providing professional services such as your accountant or lawyer)
• Repairs and maintenance
• Travel expenses
• etc.

This is also the section where a small business owner can get themselves into the most trouble. This is where bookkeepers will see a lot of "creativity" in defining a legitimate business expense. As such, if you ever have the misfortune of being audited by the CRA, IRS, HMRC, etc, this is where they ask a lot of questions. Here are some general guidelines.

• Paying for it with your business credit card does not make it a business expense.
• A lunch meeting with a client is a business expense, but is only 50% tax deductible in most places.
  • The breakfast you grabbed at McDonald's on your way to work is not a business expense.
• The $70 oil change on the company vehicle is a business expense.
  • The $70,000 company vehicle is not a business expense. We'll talk about assets and capital expenditures in the balance sheet post.
• Keep your receipts for any business purchase you make, and be prepared to explain how it was used for the business.

Look for savings opportunities here.

When you're just starting your small business, this is where you want to cut costs. You have to buy the products you're going to sell, but you can cut down on your administrative expenses. You don't want to be a Silicon Valley punchline of the company that has a bouncy castle and an indoor pool before they figure out what they want to sell. Here are some tips.

• Review your software subscriptions, as they tend to add up.
• Work from home if you can.
• Do everything yourself for as long as it makes sense.
  • Then hire for positions that will free up your time so you can focus on growing the business. Like a bookkeeper for example.

Operating Income (or Loss)

If you have a pretty simple income statement, you might jump straight to net income. For others, you will now see your operating income. This shows you the company's earnings from its normal business operations. In other words, it excludes some of the income and expenses that will show up below that are not part of regular day-to-day activities.

The formula is:

Gross Profit - Operating Expenses = Operating Income

See the section on net profit for suggested targets.

Non-Operating Expenses

You may see a section at the bottom of your income statement that shows a section for "other" income and expenses. This might be named Other Income and Expenses, or something along those lines. These are income and expenses that don't relate to the day-to-day operations of the business. This is where you may find certain tax payments, interest payments, investment income, or gains and losses from currency exchanges.

Pre-Tax Income

You may have a section of your report that shows pre-tax income. This is essentially your operating income before any income tax has been deducted. This is more often shown on an annual report since you don't typically track your income taxes month-to-month.

Income Taxes

If you're reviewing your monthly income statements, you probably won't see a section for income tax. However, once your accountant has filed your returns, you will see this in your annual reports. If your business had a net loss for the year this should be zero. Otherwise, you will see how much income tax you paid in that specific reporting period.

Net Profit

This can also be referred to as net income, net sales, net earnings, but hopefully not net loss. The formula is:

Gross Profit - Total Operating Expenses - Non-Operating Expenses - Income Taxes = Net Profit.

It's expressed as a dollar amount. You will usually see this accompanied by net margin or net profit margin. The formula is:

Net Profit divided by Revenue = Net Profit Margin

This is expressed as a percentage.

What is net profit?

Net profit is an indication of how efficiently your entire business is running.

This is another reason why knowing your gross and net profits is so important.

If gross & net profits are strong, you're doing something right. The next step is to keep them both positive and to increase each of those profit margins.

If gross is strong but net profit is negative, there are two over-simplified explanations.

1. You're selling your work at the right price, but you're just not selling enough.
2. You're spending too much to run your business.

This is where you'll want to monitor these financial statements monthly to spot trends. In the beginning and during a season when the business is expanding, you may have a month or two when your margins are too low.

This is often the case when you've landed a big new project, which requires more staff or more supplies, but you haven't completed the work yet. If you see the margins steadily increasing as the new revenue starts matching the new expenses, you should be fine.

This is the time to look for inefficiencies that aren't tied to this growth. Cut any expenses that aren't helping your business grow. You should also start planning some scenarios if things don't improve. That's a topic for another day. If you're struggling with your margins and need some advice, contact me. I can review your financials and offer some advice on how to turn things around.

What's a "good" net profit margin?

This will vary depending on the season your business is in. If you're trying to aggressively grow the business you may be fine with small single-digit net margins or even small losses. This may be because you're offering discounts to attract more work or hiring more staff to get ready for a big project.

For many small businesses, a net margin between 10-20% is a common target. If you want to set your sights on Apple's numbers, they've been hitting over 20% since at least 2010.

Final Thoughts

I know it's tough running a small business, especially if you're doing it by yourself. Unless you're a bookkeeper, you probably didn't start the business with experience reading financial statements.

As I get older, I find it really important to help freelancers and business owners better understand their income statements. Too many businesses shut down every year. I know bookkeeping alone isn't going to stop that, but this is what I know. You don't want my marketing or sales advice. The goal is to help you better understand your company's financial health.

I hope this has been helpful. If you have any questions you can leave a comment or contact me directly. I'm always happy to help.

If you did find this useful, I'd really appreciate it if you signed up for my free newsletter. You'll get the latest posts as well as tips that I don't share anywhere else.