An income statement, otherwise known as a profit and loss (P&L) statement, is a critical financial document for your business. Income statements produce a clear snapshot of all of your business activities, allowing you to quickly determine whether you’re making a profit or loss.
Having this information readily available is essential, as it can help you make decisions regarding spending and investing. When you use an income statement with your cash flow statement and balance sheet, you’ll gain a complete look at your company’s financial health.
Many first-time business owners don’t understand that there are two different income statement formats available in financial accounting: single-step and multi-step. What are the differences between the two? And what information do you need to include when compiling the documents? Below, you’ll find a complete breakdown of single and multiple-step income statements.
What is an income statement?
The income statement is a recap of your company’s income and expenses over a specified period. Business owners tend to want to analyze income statements either monthly, quarterly, or annually.
The period you choose depends on your needs. If you’re using the documents to track your operating income, you may find it better to use quarterly or monthly statements. If you need the report your income for a loan application, you’ll likely need to provide an annual income statement.
Income statement formats
When creating an income statement for your small business, you have the option to use either the single-step income statement or multiple-step statement. There are critical differences between the two that you’ll want to consider.
Single-step income statement
Single-step income statements are the much simpler option of the two. These statements merely subtract total expenses from total revenue to produce net income.
As such, you’ll only find two sections on a single-step income statement. One part is for all revenues, including both operating and non-operating revenue. The second section is for all expenses, including both operating and non-operating expenses.
Business owners who sell services may elect to use a single-step income statement since there isn’t much need to distinguish between operating and non-operating transactions. Single-step income statements are convenient because of how simple they are and how quickly owners can compile them.
The formula to calculate the single-step format is:
Net income or loss = total revenue – total expenses
If this equation yields a positive amount, you have a net income. If it produces a negative amount, you have a net loss.
Multi-step income statement
The other option is a multiple-step income statement. These income statements are similar to single-step income statements, except they break down revenue and expenses into both “operating” and “non-operating” categories. A multi-step income statement will also include a third expense category, “Cost of goods sold,” to break down and analyze costs.
Operating expenses are those that relate directly to the main activity of the business. This could include things like administrative expenses. Non-operating expenses are those that are not associated with the company directly like interest expenses or tax expenses.
Typically, those who produce or sell goods use multiple-step income statements because there is a greater need to understand the differences between operating and non-operating transactions. Examples of these types of businesses include manufacturers and retailers.
The formula for a multi-step income statement is:
Net income or loss = (total operating revenue + total non-operating revenue) – (total operating expenses + total non-operating expenses + cost of goods sold)
Cost of goods sold are all of the things that go into the production of a product. For instance, if you purchase raw materials or machinery to make a product, you would put these expenses under cost of goods sold, since you could attribute them directly to the production of your product.
Any other expenses that are directly relevant to your business, but perhaps not the production of a product, would be classified as operating expenses. As we mentioned, you could categorize administrative expenses, like the hourly wages of your employees, as an expense necessary for the day-to-day operation of your company.
Further understanding your revenues and expenses
Your income statement is comprised of two major categories: revenue and expenses. It’s essential that you know the numbers to include in each of these categories.
Revenue is all income that a company receives. This includes:
- Operating revenue from the sale of goods and services.
- Non-operating revenue, such as interest received on loans made by the company or rent received when subleasing space.
- Gains on the sale of long-term assets (like profits made from selling a vehicle, building, etc.) or other gains (like money you earned in a lawsuit recovery). Gains reported on the income statement are different from gross proceeds on a sale. The gains reported on an income statement are the amount by which the proceeds exceed the asset’s value on the company’s books.
If you are using the accrual method of accounting, you report revenue on the income statement when you provide goods or services to the customer or client. Revenue for this purpose does not depend upon the receipt of payment.
For example, if you perform a service, you need to account for revenue on the income statement when you complete the work, even though you have not yet received payment. The type of payment that you receive is better-reflected on the balance sheet. You can include categories like “Accounts Receivable” for money that your company is owed on the balance sheet, but not on the income statement.
Whether you’re paid on the spot or are expecting payment in the future, the results are the same when it comes to calculating revenues for the income statement. You can calculate revenues immediately upon sale.
This is not the case if you are using the cash method of accounting. The cash method of accounting records revenue when you receive cash. For instance, imagine you complete a service and provide the client with an invoice due in 30 days, which the client pays on time. You would end up recording the revenue nearly a month after completing the service.
You should list the total costs that you incurred when producing and selling a product. Separate your expenses into various categories to help you better see how you’re spending money. Typical types of expenses include:
- Operating expenses: The cost if you have payroll, overhead (e.g., rent, utilities, insurance, communication costs, etc.), and marketing.
- Non-operating expenses: The non-core costs of doing business, the most significant are interest expenses, which account for interest payable for debt, such as bonds, loans, lines of credit, etc.
- Cost of Goods Sold: The expenses that you can directly attribute to the production of a good, such as the purchase of raw materials and costs associated with inventory.
- Losses: Losses on the sale of assets and lawsuit damages, these are reported on the income statement. They’re the amount by which the proceeds are less than the asset’s value on the company’s books.
Expenses also vary depending on the accounting method that you’re using. If you use the accrual method, you recognize expenses upon purchasing a good or service on credit, or you receive a bill that you have yet to pay. Under the cash method, you recognize an expense upon paying the invoice or bill.
Maximizing the multi-step income statement
Now that you have a better understanding of the components that make up an income statement, you’ll want to learn how a multi-step income statement can work for you. A multi-step income statement is much more complicated than a single-step statement, but the benefit is that you have access to significantly more financial information.
One of the most significant benefits afforded to you when using a multi-step income statement is the ability to calculate gross profit, otherwise known as your gross margin. The formula for gross profit is:
Gross profit = net sales – cost of goods sold
The formula for net sales is:
Net sales = total sales – sales discounts – sales returns and allowances
Gross profit provides you with a snapshot of how much you’re making after deducting the costs associated with selling a product. It’s the first key indicator of financial stability. Knowing how to calculate gross profit can be useful when determining your pricing strategy. But you could also calculate the gross margin ratio, which is:
Gross profit margin ratio = gross profit ÷ net sales
Gross profit margins can vary from one industry to another. You should strive to match or exceed the gross profit margins for your industry. If your gross profit margins are low, you can consider increasing your price point or decreasing cost of goods sold.
A multi-step income statement also allows you to calculate your operating income. The formula for operating income is:
Operating income = gross profit – total operating expenses
Where gross profit enables you to determine how much you’re making on a particular good or service, operating income demonstrates how much profit you have after accounting for all aspects of business operations.
Say, for instance, you sell a product, and you notice healthy profit margins. However, after calculating operating income, you see that you’re breaking even. This is a sign that your operating expenses are too high and that you need to find ways to cut back. Operating income is also known as “Earnings Before Interest and Taxes.”
Net income allows you to determine how much you’re earning after accounting for all expenses. If operating income determines “Earnings Before Interest and Taxes,” then net income would determine “Earnings After Interest and Taxes.” The formula to calculate net income is:
Net income = operating income + non-operating revenue – non-operating expenses – income tax expense
Similarly, once you have a net income, you could also calculate comprehensive income. Comprehensive income provides a much more detailed look at income since it accounts for all incomes related to the business, including those that are not part of net income.
Comprehensive income provides business owners the opportunity to account for unrealized gains and losses. For instance, owners could classify gains and losses from the company’s investments in stocks or mutual funds as comprehensive income. If an owner were to see gains on comprehensive income, the market value of the stock or fund would be higher than the price at which the owner purchased it. Similarly, losses would occur if the market value was lower than the purchase price. The formula to calculate comprehensive income is:
Comprehensive income = net income + other comprehensive income – other comprehensive expenses
How to format your income statement
If you’re using your income statement strictly for internal purposes, it doesn’t really matter how it’s formatted. You’ll want to make sure you include the elements listed above to ensure that the document is thorough and accurate. You may find this free template useful when it comes to compiling your income statement.
You should know, however, that there may be some circumstances where a specific income statement format is required. For instance, if you’re applying for a loan, the bank may wish for you to have formatted your income statement in a particular way. Be sure to follow up on this before submitting your information.
This is also one of the reasons why multi-step statements are useful — even if your revenues and expenses are straightforward. Imagine that you’ve always used a basic single-step income statement. When you apply for a loan, you’re required to submit a multi-step statement. You now must waste valuable time trying to sort through everything on your income statement to figure out what goes where. It’s easier to go from a multi-step statement to a single-step statement than vice versa.
Take time when compiling your income statement
The income statement is a critical component of a company’s financial statements. Accurately preparing an income statement at least once per quarter will help you evaluate the financial health, value, and growth of your company. A proper income statement, when used in tandem with a balance sheet and cash flow statement, can provide you with the type of insight that leads to organizational growth.
This article originally appeared on the QuickBooks Resource Center and was syndicated by MediaFeed.org.
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