How to prepare an income statement

Learning to prepare an income statement is the first step in understanding how to read one. This may seem like a task best left to the accountants, but small business owners can benefit from the knowledge we are about to impart in this article.

This is because income statements are essential for measuring your company’s financial performance and efficiency, helping you track net income and make informed decisions.

What is an income statement?

An income statement, also called a profit and loss statement or loss statement, shows your business’s total revenue, operating expenses, gross profit, and net income over a given period. It’s one of the core financial statements that helps assess your company’s financial performance.

Income statements are crucial for business owners, CFOs, and investors as they provide a clear view of a company’s profitability. The statement also helps with budgeting and identifying areas where your business can improve its operating income and reduce cost of goods sold (COGS).

Why is an income statements important?

Income statements are commonly used as profit and loss statements (P&L) to calculate a company’s profitability metrics. The “net income” number at the bottom is particularly important because it’s used as a variable in the “return on assets” and “return on equity” business ratios.

Another insight the income statement can provide is whether your company efficiently spends money, which is becoming increasingly important in this economic climate. Expenses are categorized to be examined individually later if you’re looking for areas where you can cut costs. Income statements from different reporting periods can also be compared to see how revenue and expenses have changed.

The SEC requires income statements and the other reports listed above for all companies trading publicly on the stock exchange. These reports give investors and shareholders the transparency they need to make financial decisions. Failure to produce financial reports could lead to heavy fines and delisting on the stock exchange.

For private companies, income statements are useful for tracking revenue and expenses, determining whether your business is producing an income, and analyzing costs. It’s a good idea to get in the habit of creating them in case you ever want to go public. They could also be helpful at the bank if you plan on financing any debt for growth or expansion.

What should an income statement include?

An income statement includes several key line items that help break down your company’s financial performance. Here's a breakdown:

How to do an income and expense statement

The three main elements of an income statement are revenue, expenses, and profit. Profit, which is typically listed last on an income statement, is used to calculate net profit margin. That’s the origin of the term “bottom line.” Here are eight steps to get you there:

Step #1: Choose the reporting period

Corporations set their fiscal year-end date when they file their articles of incorporation. That’s when you want to file your annual report, but it’s not the only time you should make an income statement. Public companies file quarterly, keeping reports in line with quarterly tax deposits. You can also do these monthly if you like. Be sure to choose the reporting period before you begin.

Step #2: Calculate your revenue

Under GAAP accounting rules, corporations are required to use the accrual method to keep track of incoming revenues. That means the revenue is recorded at the time it is earned, not when it’s received. This is important for companies offering net payment terms to clients and customers. You’re not counting cash received. You’re tallying invoices by date.

Step #3: Calculate COGS/Cost of Revenue

Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company combined with the costs for sales and distribution. The direct costs include labor and materials. In the example above, COGS is listed among the expenses. Some companies prefer to have it in the revenue section so they can have a “gross margin” before expenses on the report.

Step #4: Calculate gross margin

Gross profit margin (GM) is important for determining whether your products are correctly priced, but it doesn’t need to be a subcategory on the income statement. If COGS is listed in the expense section, you can easily calculate gross margin by subtracting it from gross revenue (GR) and dividing it by gross revenue. The income statement formula looks like this:

GM = (GR – COGS) / GR

Step #5: Factor in total operating expenses

All businesses have operating expenses. They include salaries, rent, utilities, transportation, advertising, and marketing. If you have an automated accounting system, these should already be categorized for you. If not, you have some manual labor to do before you can create this report. Categorization is critical if you want to get the most out of your income statement.

Step #6: Calculate operating income

Subtract your total expenses from your total revenue to come up with your operating income, which is the company's net income before taxes. If interest and depreciation expenses are listed below this line, the net income is called EBITDA (earnings before interest, taxes, depreciation, and amortization). Our example above does not include that.

Step #7: Calculate tax

Taxes are inevitable. If you’re using a spreadsheet application like Excel to create your income statement, you can enter the tax rate into the appropriate field as a formula. For instance, a 25% tax rate would be entered as [= (Cell Number) *.25.] This will autofill the tax box as you enter revenues and expenses. That will tell you what you owe for a quarterly tax deposit.

Step #8: Calculate net income

Subtract taxes and depreciation expenses (if applicable) from your operating income or EBITDA to get the bottom line: net income. You’ll be able to see if your company made a profit. Your shareholders and C-suite executives also might find that information useful.

How to analyze income statement

Now it’s time to analyze the key metrics. Here’s what to focus on:

Gross profit

The gross profit margin is a key metric to assess the profitability of your core business activities. It’s calculated as:

Gross Profit Margin = (Gross Profit / Total Revenue) × 100

A higher gross profit margin means your business is efficient at generating revenue from its direct costs. If this figure is low, you might want to evaluate cost of goods sold (COGS) or pricing strategies.

Operating income

Operating income measures your company’s profitability from regular operations, excluding non-operating expenses like taxes or interest. If your operating income is shrinking, it could indicate increasing operating expenses, such as higher administrative expenses or inefficiencies in operations.

Net income

The ultimate figure on the income statement is net income, which shows your business’s overall profitability and allows you to understand the final outcome of all your business activities. If your net income is negative, consider reducing unnecessary expenses or increasing sales revenue.

EBITDA and EBIT

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and Earnings Before Interest and Taxes (EBIT) are often used for further analysis. These metrics exclude non-cash expenses like depreciation and amortization, providing a clearer picture of operational profitability.

Example of an income statement

Here’s a sample income statement for a small business:

This statement shows that the business generated $500,000 in revenue, with $250,000 going toward the cost of producing goods. After deducting operating expenses, the company earned $130,000 in operating income. The net income is $95,000 after factoring in taxes and non-operating expenses.

Pitfalls and advanced tips

Even seasoned professionals can make mistakes when preparing income statements. Here are some common pitfalls and advanced tips to avoid:

1. Misclassifying expenses

One of the most common mistakes is misclassifying expenses. Be sure to separate operating expenses from non-operating expenses, such as interest expense or income tax expense. Misclassification can lead to misleading figures in operating income and net income.

2. Overlooking depreciation and amortization

Depreciation and amortization are often overlooked or incorrectly calculated. These are non-cash expenses that reduce the value of assets over time. Failing to account for them can inflate your net income and mislead decision-makers.

3. Underestimating income tax

Always factor in your income tax expense correctly. Taxes can vary based on tax rate, applicable deductions, and jurisdiction. A miscalculation can result in a huge discrepancy between your actual and reported net income.

4. Not using automation tools

Relying on spreadsheets without accounting software tools can lead to errors. Using accounting software such as Ramp automates many of the calculations, reducing human error and ensuring accurate data.

Enhance the accuracy and efficiency of your income statement with Ramp

Accurate financial reporting is essential for understanding your business's financial health. By automating the preparation of your income statement, you can eliminate manual errors, streamline your workflow, and gain real-time insights into your financial performance.

Ramp’s accounting automation software simplifies this process by integrating your financial data, automating the creation of income statements, and providing actionable insights into profitability. It transforms your accounting operations with powerful automation, reducing the time spent on manual data entry and reconciliation.

Empower your team to make informed decisions faster while Ramp takes care of the tedious tasks.