How to Read an Income Statement

financials

For many new in the business world, reading an income statement can be a confusing and intimidating experience. However if you know where to look you will realize that it is not as intimidating as it may appear. Understanding an income statement is a very important skill to have for entrepreneurs as it aids with making sound business decisions. Basically, an income statement tells you how much money came into your company during a specific period, how much a business spent in order to generate income, and how much profit a business has after having paid all expenses. Here are a few points that will make income statements easier to understand.

  1. Income statements cover a period of time

Before you delve into reading the income statement, make sure to take note of the specific time period covered. Questions you should be able to answer for the said period include: What are the revenues of the company during the period? Have the revenues increased or decreased over the last few periods? What are the various components of cost? How profitable was the company during this period? What are the earnings attributable to a share or the Earnings per Share?

 

  1. Income statements follow a simple formula

Income statements may have slight variations, depending on the company. However, they all possess the same data. Essentially, total revenue, total expenses, and net income (Total revenue-total expenses= Net income). Additional information is simply added in order to give the reader a more detailed depiction of financial status.

  1. Don’t let the jargon throw you off

What can make income statements difficult to understand is wording. Keep in mind that businesses can use different words to describe the same concept. For instance, the term “sale” or “income” can be used instead of “revenue”. The word “expenses” can be used instead “costs.” “Profits” and “net income” are also interchangeable.

 

  1. Expenses are often split into different parts
Expenses tend to be broken down into components. Cost of Goods Sold is the direct cost attributable to goods sold. Selling, General and Administrative Expenses combines payroll costs, except for what has been included in labour costs. Depreciation and amortization are charges with regards to fixed and intangible assets that have been capitalized on the balance sheet over time. Sales & marketing, as well as Research & Development costs are also almost always included in income statements.

 

  1. Keep an eye for cash flow
Comparing an income statement to a cash flow statement is highly recommended. The reason for this is to see if the profits earned are supported by the cash coming into the company. High profits on an income statement paired with low cash flow can imply weak quality of earnings. Know your key drivers and manage them. Keep a careful eye on areas that affect cash flow: accounts receivable collections and inventory turnover. How are you doing compared to past performance and your peers? Watch key areas that affect profits, net and gross margins, labor and fixed asset utilization. Though this is more acceptable with start-ups since they likely have to make substantial inventory investment before collecting from customers, this is something that should improve over time.

 

  1. Take note of the profit margin and earnings per share

The profit margin will give you an indication of the percentage of revenue that is left for shareholders after expenses are paid. Earnings per share will tell you the portion of earnings you would be entitled to if you owned one share.

 

Income statements can be very intimidating if you are a first-time business owner. If you are an entrepreneur needing help with your financial statements, remember that some aspects of running a business are not worth saving money on. There’s no need to turn yourself into a CPA, but you must be able to read financial statements, talk with better qualified financial people and assess your company’s performance.This will lower your stress level and get the job done efficiently.

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