What is an Income Statement (Profit and Loss Statement)?

Every business, small or large, needs to keep an eye on some basic numbers in order to be able to pay taxes properly and take actions that are necessary to guide the business in the right direction. Here, we will talk about some of the most important (and basic) ones that every business owner should know. We will try to go from the most general ones to most specific ones, thereby allowing you to use these numbers in your own accounting calculations.

The numbers we will look at in this post will come from what is known as an income statement (also known as profit/loss statament or P&E Statement). This report consists of one of the most important numbers that reflect the financial performance of a company.

An income statement includes the details of the revenue from sales and services and start deducting certain expenses until a net profit is reached. Below, you can find the details of each item in a typical income statement.

Gross Sales (Total Revenue)

Gross sales are the sum of all sales transactions reported in a certain period of time. This includes no deductions; therefore, it can be misleading when reported on its own without the rest of the balance sheet.

Still, it is a useful measure of the overall sales activity of a business. It is usually used as a measure of market interest in the product or service. If the gross sales are growing (or at least if they are growing in comparison to the competitors), it is a good sign of market interest in the company or the sector in general.

Example: If a company sells 1000 of a Product A for $50 in a year, the gross sales of that company is $50,000.

Even in "gross sales" and "total revenue" can be used interchangeably, the difference between the two comes from whether the sales is realized or not:

• Gross Sales: Sum of all the invoices for the products.
• Total Revenue: Actual cash and money (funds) received by the company. This excludes the amount that could not be collected yet for various reasons.

Net Sales (Revenue, Sales Revenue)

Net sales are the total revenue, less the cost of sales returns, allowances and discounts. These 3 items can be defined as follows:

• Sales Returns: Merchandise or service returned by the customer for various reasons, such as excess quantity shipped, defective goods, wrong item, etc.
• Sales Allowances: These are reductions in the price charged by a seller when there is a problem with the product/service, especially in terms of quality or price errors. For example, if the product was shipped with wrong specifications, the seller can convince the buyer with an allowance of $1,000 so that they keep the product.
• Discounts: These are reductions in price in exchange for early payments from customers. These are not exactly "promotional discounts" we see in stores. These are more like "Pay before Date X to get 20% off." type of deals.

Therefore, if the a company with a gross sales of $50,000 had $5,000 in returns, $3,000 in allowances and $2,000 in discounts, the net sales of the company is actually:

$50000-5000-3000-2000=40000$

This number is also known as top line as opposed to "bottom line" we will see shortly. This comes from the fact that net sales are usually at the top of the balance sheet.

Gross Profit (Gross Income)

Since it is usually not free to make a product to sell, the profit from each sale (or from the total of sales) is not the same thing as the revenue. There are various expenses that the business must make in order to manufacture and sell its products. Gross Profit is what is left after certain kinds of these expenses. These expenses can be categorized under two broad categories:

• Cost of Goods Sold/Sales (COGS): These are direct expenses that arises from the costs of producing the goods sold by a company.
• COGS do include:
• materials,
• labor costs (to make the product),
• shipping costs to obtain the product,
• equipment,
• sales commissions, and
• depreciation that results from the production.
• COGS does not include:
• distribution costs (shipping to the customers),
• office supplies,
• labor or sales force costs (for non-manufacturing personnel)
• advertising costs,
• rent,
• insurance expenses,
• employee benefits
• Depreciation and Amortization: These are non-cash expenses on the income statement. Depreciation arises from the cost of capital assets being used over time. Amortization is the cost of using intangible assets (like intellectual property, goodwill, etc.) over time.

Therefore, the gross profit can be calculated as:

$\text{Gross Profit = Net Sales (Revenue) - COGS - Depreciation - Amortization}$

Gross Profit Margin

We can use a simple formula to determine how efficiently a company is producing its products or services, compared to its competition (or to its historical performance). This is done by:

$\text{Gross Profit Margin}=\frac{\text{Gross Profit}}{\text{Net Sales (Revenue)}}$

Net Profit (Operating Profit, Net Income, Bottom Line)

Since the gross profit excludes some of the expenses (that are actually important in the health of the business), we can calculate net profit by:

$\text{Net Profit = Gross Profit - Operating Expenses - Interest - Tax}$

We can analyze each of the negative terms as:

• These other expenses (aka operating expenses) include:
• All general and administrative expenses such as:
• payroll,
• rent,
• distribution costs (shipping to the customers),
• office supplies,
• labor or sales force costs (for non-manufacturing personnel)
• advertising costs,
• rent,
• insurance expenses,
• employee benefits
• Non-operating expenses and losses such as:
• Incidental (peripheral) expenses that are not relevant to the main operations,
• Losses, in the sense that disposal of property, plant and equipment for a cash amount that is less than the book value (carrying amount) of the asset sold.
• Interests are the interests on bank loans.
• Taxes paid to the state and the federal government.

Accrual vs. Cash Methods

Since small businesses determine taxes based on net profit in most scenarios, at the end of the year (while closing books), a very crucial distinction must be realized that may cause problems if overlooked:

Depending on the accrual method vs. cash method used by the company, accounts payable (A/P) and accounts receivable (A/R) may be considered as "expenses" (or more accurately, might be added or subtracted from the Net Profit calculation "as if they are income or expenses").

This is because in accrual accounting method, a company assumes an account receivable/payable realizes the transaction the moment it happens, even if the money has not hit the account yet. Therefore, the equation becomes:

$\text{Net Profit = Gross Profit + A/R - A/P - Operating Expenses - Interest - Tax}$

This is not the case for the cash method.

Important Detail for Tax Expenses

It is extremely important to note that only the portion of the payroll taxes paid by the company should be marked as expenses in the income statement. This means that the portion withheld from the employee is not a tax expense.

Other taxes paid to the state or the government are also included in the business expenses.

More Details on Net Profit

Sometimes businesses choose the differentiate between operating profit and net profit by defining:

• $\text{Operating Profit = Gross Profit - Operating Expenses}$
• $\text{Net Profit = Gross Profit - Operating Expenses - Interest - Tax}$

You can even go further by defining:

• $\text{Net Profit Before Tax= Gross Profit - Operating Expenses - Interest}$
• $\text{Net Profit After Tax = Gross Profit - Operating Expenses - Interest - Tax}$