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.
What is an income statement?
An income statement is a document that begins with your gross revenue and subtracts your COGS, expenses, and taxes to give you the net income for a specific period of time. The income statement is one of four financial statements required by the SEC if you’re a public company. The other three are the balance sheet, statement of cash flows, and statement of shareholder equity. None of these are required if you are a private company with no stockholders, but it’s a good idea to prepare them anyway.
Why are income statements important?
Income statements are commonly used as profit and loss statements (P&L) to calculate a company’s profitability metrics. For more on that, read our article on how to analyze a P&L statement. 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 is efficient in the way it spends money, which is becoming increasingly important in this economic climate.
Expenses are categorized so they can 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 over time.
The SEC requires income statements, along with the other reports listed above, for all companies that are 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 useful at the bank if you’re planning on doing any debt financing for growth or expansion.
How to prepare an income statement in 8 steps
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 do 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
Corporations are required under GAAP accounting rules 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 an important number for determining whether your products are priced properly, 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 then dividing it by gross revenue. The 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, marketing, and others. 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 net income of the company 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 might find that information useful also. Do they get a bonus or dividend if the company hits a certain number? That’s a topic for another day.
Important notes on income statement creation
Terminology is important. Two terms that are commonly confused are “revenue” and “income.” The income statement clearly shows the difference between the two. Revenue is essentially your total sales number. Net income is revenue minus expenses and taxes. That’s not the same as EBITDA, which is income before taxes and depreciation expenses.
Don’t worry. We’re not going to quiz you at the end of this article. Accountants need years of schooling before they fully understand all this. Focus on the math:
Net Income = Revenue – Expenses – Taxes
The net income number carries over to be the first line of the cash flow statement, so it needs to be accurate. Always double-check your work before finalizing your report.
Learning all this will help you better understand how to financially analyze your own company and others. You might also want to check out our article on how to create a balance sheet to gain a better understanding of financial reporting in general.
Tips to improve your income statements
Accurate financial reporting is important for several reasons. Obviously, you want to know how much money your company is making or losing. Income statements can help with that even if you’re a small private company with no public shareholders. Larger companies and public corporations have investors and regulatory bodies to answer to. Inaccuracies in that space are costly.
There are steps you can take as a business owner to improve the quality of your income statements and other financial reports. Getting the right tools to track sales revenue and calculate liabilities is a key area to focus on. Finding the right people to prepare your reports is another. We suggest the following three steps if you want to improve your income statements:
1. Utilize automation
You probably know by now that Ramp is a platform that utilizes automation and API technology to connect your expense tracking in our platform with your accounting software. This error-free flow of data to the platform where you’ll create your income statement can save you hours of work and eliminate any chance of error that you’d have with manually entering that data.
2. Use financial management tools
Modern financial management tools can help you categorize expenses, track spending, and plan for growth and expansion. They can also help you keep track of cash inflows and outflows in real time, an essential feature to have when you’re doing accrual accounting. Ramp can handle your expense tracking. Tools like Quicken and NetSuite can do the accounting.
3. Let the accountants handle financial reporting
You cannot afford to make mistakes when creating financial reports. It’s good to know how to create an income statement, a balance sheet, and a cash flow statement, but that doesn’t mean you should. Ramp automation and API connections to accounting software gives you the tools you need to run a report on your own. Do that often, but let the accountants handle the actual filing, especially if you’re at the helm of a public company.