A Straightforward Explanation of a Company’s Income Statement

By Randall Orser | Small Business

Income Statement word cloud TNWhen companies want to track their financial performance over a given week, month, quarter or year, they turn to the information provided through their income statement. Sometimes referred to as an “operating” statement, a “profit and loss” statement or even an “earnings” statement, this financial reporting structure aims to define a company’s performance in terms of its revenue, the changes in its inventory values, its product’s COGS (cost of goods sold), its gross profit on sales, its expenses, and most importantly, its net profit for the period in question. We’ll review the income statement by taking a straightforward look at the activities of a company during a given month.

The Income Statement

The income statement is but one of the three key financial reporting structures for all enterprises. The others include the balance sheet and cash flow statement. However, while the balance sheet is viewed as a snap shot in time, and the cash flow statement tracks incoming versus outgoing cash from the business, the income statement is seen more as a time based representation of the company’s activities. While the income statement itself can be quite complex, ours will be simplified by focusing on the transactions of a company over a single month. In order to do that, we’ll outline the income statement by defining the relationship between a company’s sales, COGS, gross profit, expenses and net profit.

Sales, COGS, Gross Profit, Expenses and Net Profit

Gross profit is simply sales minus COGS. When thinking of COGS, think of those costs that go directly to making a given product. Determining the company’s net profit simply involves taking the gross profit and deducting the company’s expenses. When thinking of expenses, think of the cost of doing business. Expenses are costs that the business must absorb regardless of how many products it makes.

There is a simple approach to determining COGS and how they can be represented on an income statement. In our income statement, the company’s starting inventory values are added to that month’s new inventory purchases. This total is then subtracted from that same month’s unused inventory values. The calculations to determine COGS, gross profit and net profit are summarized below:

A) COGS = Starting Inventory Value + New Inventory Purchases – Ending Inventory Value

B) Gross Profit = Sales – COGS

C) Net Profit = Gross Profit – Expenses

Our income statement is a summary of the company’s activities for the month of July 2011. The company had revenue of $20,000.00 for the month. At the beginning of July, the company had $1,000.00 left over in unused inventory that wasn’t used or sold in the previous month of June. This is represented by the “starting inventory value” ($1,000.00) in the income statement. In the month of July, the company purchased additional inventory, which is included under the section “new inventory purchases”, the total of which is $10,000.00 ($2,000.00 + $2,000.00 + $4,000.00 + $1,000.00 + $1,000.00). At the end of July, the company had used up all but $3,000.00 of its inventory. This $3,000.00 is the company’s “ending inventory value”.

A) Here is the calculation to determine “COGS”.

COGS = Starting Inventory Value + New Inventory Purchases – Ending Inventory Value

COGS = $1,000.00 + $10,000.00 – $3,000.00

COGS = $8,000.00

B) Here is the calculation to determine gross profit.

Gross Profit = Sales – COGS

Gross Profit = $20,000.00 – $8,000.00

Gross Profit = $12,000.00

C) Here’s the calculation to determine net profit.

Net Profit = Gross Profit – Expenses

Net Profit = $12,000.00 – $3,000.00

Net Profit = $9,000.00

Putting the Income Statement Together

The first step is to define the time period of the income statement. Our example is for a company’s activities during July 2011. The second step includes the company’s revenue for the month, which in our example is $20,000.00 in sales. The third step includes stating the starting inventory values for July. This is inventory that was not used or sold in the previous month of June. Don’t be confused with the beginning inventory value. This is inventory the company wasn’t able to sell during the previous month. The fourth step includes accounting for the new inventory the company purchased in the month of July. Why would a company purchase more inventory when it already has inventory from the previous month? Simply put, companies often have large product portfolios, the likes of which forces them to purchase large amounts of inventory. All companies carry some amount of inventory from one month to the next. The fifth step includes summarizing the unused inventory, or better put, the “ending inventory value” for July. The sixth and seventh steps include determining the COGS and gross profit. The eighth step includes itemizing the company’s monthly expenses. The ninth is to add up the expenses and finally, the tenth step determines the net profit. All ten steps are highlighted in bold  in the income statement below.

Income Statement (1) July 2011
  (2)    Revenue $20,000.00
Starting inventory value  (3) $1,000.00
New inventory purchases  (4)
aluminum $2,000.00
nuts $2,000.00
epoxy $4,000.00
steel $1,000.00
copper $1,000.00
Ending inventory value       (5) $3,000.00
COGS    (6) $8,000.00
Gross Profit  (7) $12,000.00
Expenses   (8)
advertising $1,000.00
equipment maintenance $750.00
insurance $500.00
rent $250.00
office supplies $500.00
Total Expenses (9) $3,000.00
Net Profit   (10) $9,000.00

Notice how the net profit is at the bottom of the income statement? That’s why it’s called the “bottom line”. By no means is this the only way to depict the income statement. For instance, it’s not uncommon for companies to simply sum up their COGS separately. However, the basic premise remains. To determine gross profit, take the sales and subtract COGS. To determine net profit, take the gross profit and deduct the month’s expenses.

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