Q. I have recently hired an accountant to do the books for my small business. Each month she gives me an income statement, but I don’t understand what it is trying to tell me. Can you help me understand this?
A. One of the most frequent things we encounter in working with small businesses is owners who don’t fully understand how to read their financial statements. Below are six tips that will help you understand what your income statement (also called a Profit and Loss Statement or a P&L) is trying to tell you.
1. Income statements cover a period of time – The income statement is a view of how much money your business made over a period of time. Most often, the income statement reflects performance over a month, a quarter or a year. You will also see year-to-date income statements which reflect activity from January 1st through the current date (usually the end of a month). For example, you might see Y-T-D August. This indicates that the period covered by the income statement runs from January 1st to August 31st. The important point is that income statements always covers a period of time. It is important to note the timeframe.
2. Every income statement follows a simple formula – Every income statement, no matter how complex it may seem, follows a very simple formula:
Revenue – Expenses = Profit
That’s it. It really is that simple. For whatever period the income statement covers, it shows the revenue the business earned, the expenses it incurred and the profit the company made.
3. Multiple names for one item causes complexity – One thing that can make income statements seem more complex is that people use different names to refer to the same thing. For example, the term sales or income can be used instead of revenue. Expenses and costs are used interchangeably. Profit is sometimes called net income. Don’t let the jargon throw you. Remember, no matter what terms you use; the money that comes in minus the money you paid out equals the money you get to keep.
4. Expenses are often split into multiple parts – Another thing that can make an income statement seem more complex than they are is that expenses are usually broken down into components and profit is calculated at interim levels. For example, you will often see:
– Cost of Goods Sold
– Selling, General and Administrative
In this case, expenses have been broken down into two parts: Cost of Goods Sold (COGS) and Selling, General and Administrative (SG&A). COGS are those costs related directly to the products or services that you sold. For example, the material you bought to make the widget you sold and the compensation you paid to the widget builder would be included in COGS. COGS generally vary directly with revenue which is a function of the number of widgets sold.
SG&A are those costs that, while necessary, are not related directly to the number of widgets sold. For example, the salary of the President, the CFO and the salespeople are typically included in SG&A as is the rent and the utility bills for the office building. These costs are typically more constant month to month and don’t vary with the number of widgets sold.
5. Gross Margin percent should be relatively constant – With expenses split into two parts, profit is calculated at an interim level called the Gross Margin. Gross Margin is equal to Revenue minus COGS. The Gross Margin (also called Gross Profit), is the money you receive from the products (or services) you sell less what it cost you to deliver them. It is very useful to calculate Gross Margin as a percentage of Revenue.
Gross Margin % = Gross Margin $ / Revenue
The reason this is valuable is that, as explained above COGS should move with Revenue. Therefore, Gross Margin % should be relatively constant. If there is a significant change, say from 40% in one period and 20% in the next period, this should be a red flag. While there can be completely valid reasons for such a change, it is important to understand what is going on.
6. Dollars spent on SG&A should be relatively constant – One final thing to keep an eye on is the dollars you are spending SG&A. This number should also be reasonably constant from period to period. A significant change in the dollars you are spending on SG&A should also be a red flag that causes you to dig a bit deeper to understand what is happening in your business.
Obviously, there is more to income statements than we can cover in this brief article. However, these hints will be helpful as you glean what your income statement is telling you about the health of your business.