The next financial statement that we’ll tackle is the Income Statement. The Income Statement can go by many names, “Income Statement,” “Profit & Loss Statement” or the “Statement of Income and Retained Earnings” are the most common ones. Our firm calls it the Statement of Income (or Loss) and Retained Earnings.
What is the Income Statement?
The Income Statement provides an overview on the operations or activities of a business for a specific period of time. Each year a company will need to provide an annual income statement to report to the Canada Revenue Agency with their tax return and will end up paying income taxes based on the net taxable income that has been earned by that company. Publicly traded companies will report their Income Statements on a quarterly basis to their shareholders. Many companies, both private and public, will have their financials prepared on a monthly or quarterly basis to analyze how the business is performing and to assess if any trends can be seen in sales or costs.
Things to think about when preparing your Income Statement
Since the purpose of the income statement is to tell the story of how your business did during a particular period of time, it’s important to ensure that the amounts on the income statement properly reflect what happened during that time. Some key areas to consider are revenues, cost of sales or cost of service expenses, gross profit (profit margin), and overhead expenses (often fixed costs to run your business).
On a high-level basis, if you’ve sold something, you should be recording it as revenue. However, there are some nuances that need to be considered that may change how much revenue is recognized. Here is an example. You are successful in signing a contract valued at $30,000 to deliver your services over a 6 month period, but your client pays you 50% up front and then 50% at the completion of the contract. How do you recognize the revenue? Do you recognize the $30,000 immediately? Or do you recognize the revenue on a monthly basis?
If the services provided for the contract is equal for each of the 6 months, you would recognize the revenues monthly. Your cash won’t align with the revenue recognized, but that’s ok. If you are providing the majority of the services at the beginning of the contract and very little in the last couple of months, you may have an argument, that you should be recognizing more revenues in the earlier months and less in the latter months. The business owner should discuss recognition of revenue with their accountant to ensure that revenues recognized in the period are matched with costs incurred to earn this revenue. This will ensure that profit margins are not skewed in any one period when costs and revenues are mismatched. Also, depending on the type of business you have, you may need to comply with a specific set of accounting standards. This should be a discussion to have with your accountant to see if this applies to you and your business.
Cost of Sales or Cost of Service
Similarly, the Cost of Sales or Service should also match the timing of the revenues. If the costs are not co-ordinated to be recognized at the same time as your revenues, you will end up with a financial story that will either present things better than they are or worse than they are. It is also important for you to recognize the true inputs that relate to generating your revenues. If you have inventory, it is also important for you to do an inventory count at the end of your period to ensure that your inventory value is correct. If it is understated or overstated, there is a good chance that your cost of sales amount needs to be adjusted.
Another input that should be reviewed are your staffing costs. Is there a portion of these costs that should be included in the cost of sales? If you have employees that help assemble your inventory, or if you have shipping costs directly related to the shipment of your goods, you should consider including these costs as a part of your cost of sales. Business owners and their accountants should discuss the costs associated with the sale of each product or service in order to get a true picture of gross profit and ensure your goods and services are priced accordingly to earn a profit. If not, what are you in business for?
Gross profit is calculated by taking your Revenues less your Cost of Sales. You should always aim to have a positive Gross Profit. It is the Gross Profit that provides the funds to operate the administrative side of the business. If your Gross Profit is negative, have a look at your revenues and expenses. Have things been reflected properly? If they have, are you spending too much on your inventory? Are your prices too low? From an investment point of view, a potential investor will shy away from a company who is operating with a negative or small gross profit (or a gross loss). It demonstrates that the business owner doesn’t have a firm grasp on the market that they are selling into and are digging a hole that will eventually be too hard to climb out from.
This is why it is important to ensure that your cost of sales (or service) is calculated correctly. If the price of your product or service isn’t high enough to cover your direct inputs (costs), you will need to consider increasing your sales price.
Overhead expenses are another word for administrative or fixed costs. These expenses relate to the administrative side of the business and would be required if you have sales or if you don’t have sales. Generally, these tend to be your fixed costs that will not vary as sales increase or decrease.
This would include things like salaries for your office staff, rent and insurance. Some costs will have a variable nature to them depending on the size of your business, such as advertising, meals & entertainment costs, travel, and interest charges. These costs are not usually directly tied to sales of your product or services and are therefore considered overhead expenses.
This does not mean that these costs should be ignored. It is a good idea to look at the trends of these costs. Are your advertising efforts matching with the increase or decrease in your business? Should you be reviewing your loans to see if you can receive a more favourable interest rate? How long is your lease agreement with your landlord? Do you expect your rent expense to increase or decrease in the coming months?
As a general rule of thumb, we also do not like to see overhead expenses exceed 10% of gross revenues. As revenues grow, we like to see this ratio decrease as we should not see any large swings in these costs in relation to revenue. If there are large variations, consider if any cost category currently classified in overhead expense should be considered in cost of sales instead. Then re-evaluate your profit margin and sales prices.
How to use or interpret your Income Statement
The income statement can be created at any point in time and should be reviewed at regular intervals. As your business is starting out, things are pretty hectic and crazy. So, potentially creating monthly financial statements is asking a bit too much for yourself in the first year or so. However, at a minimum, you should look at your income statement twice a year. Once at the halfway point during the year to check in to see how things are going and to determine whether or not you need to make any adjustments.
A budget can be created before your start your business. And a significant portion of your budget will be based on how you expect your business to perform in a year. The income statement portions of your budget can be used to compare against your current income statement. Are things turning out the way that you had hoped? Are things better? Are things not going according to your plan? Once you start looking at the numbers, start investigating what the numbers are trying to tell you.
If this is overwhelming or you’d like a bit of assistance getting started on the right path on understanding your Income Statement, reach out to your accountant to have them help you understand what is going on in your business. If the numbers just look like dollars to you and you aren’t sure what they are trying to tell you, spend the time to learn. Once you spend a bit of time understanding the information, it will make you a stronger business owner, one that can make informed decisions about your business. Don’t worry, it will get easier each time you review the financial information.