In this post (#2 in my series) we will review The Income Statement. I am going to guess that most people are more familiar with managing the Income Statement than the Balance Sheet (post #1) if your organization sells goods. You may know the Income Statement as the Profit & Loss Statement (or P&L for short). This is definitely the one I am most used to analyzing on a regular basis. However, I feel it is important to understand the basics of the Balance Sheet before diving into the P&L.
What is the P&L?
The P&L indicates the results of a company’s operations over a specified period. Yes, unlike the balance sheet which reported the company’s position at a specific point in time, the P&L covers a period of time. Most P&L reviews are done at the end of a month, end of a quarter and end of a fiscal year. (Note: A fiscal year is a 12-month accounting period as defined by your company. Some parallel a calendar year, others start/end at various points throughout the year.) The P&L tells you whether your company is making money or losing money. This equation is much simpler to understand and is stated as Revenues – Expenses = Net Income (or Loss).
What are Revenues?
First, it’s important to distinguish revenues from receipts.
- Revenues – occur when a sale is made or when they are earned. Revenues are frequently earned and reported on the income statement prior to receiving the cash.
- Receipts – occurs when cash is received or collected
Revenues are generally classified into 3 categories.
- Primary Activities – For a retailer, wholesaler, and distributor the primary activities would be the buying of merchandise and then the sale of that merchandise. A manufacturer’s primary activities would be the production and sale of products.
- Secondary Activities – Also referred to as peripheral activities. A company’s activities outside of its main activities of buying/producing and selling. Examples include a retailer’s financing function involving interest revenue and interest expense, disposal of long term assets used in the business, lawsuit settlements, renting out unused space, etc.
- Gains – this could be the gain on a sale of a company asset. As we learned in the Balance Sheet discussion, assets are depreciated over time. If you sell an asset for more than the book value of the asset, the difference is reported as a gain. It would not be reported as sales revenue because that account is only for the selling of the company’s merchandise (product produced).
What are Expenses?
Just like with revenues, expenses are classified into 3 similar categories. Remember, though, under the accrual basis of accounting, the cost of goods sold and expenses are matched to sales and/or the accounting period when they are used, not the period in which they are paid.
- Primary Activities – expenses that are incurred in order to earn normal operating revenues. Examples: utilities used, advertising expense, salaries, office supplies, and other business expenses used (not paid). The largest category of primary activity expense for those who produce a product is Cost of Goods Sold. Cost of goods sold is the cost of the merchandise that was sold to customers. The cost of goods sold is reported on the P&L when the sales revenues of the goods sold are reported.
- Secondary Activities – are referred to as nonoperating expenses. For example, interest expense is a nonoperating expense because it involves the finance function of the business, rather than the primary activities of buying/producing and selling.
- Losses – the loss on a sale of a company asset.
Using the P&L
Besides just noting the generally profitability of the business during the specified time, it is also good to look at the same period of time over the past 5-10 years to see if there are any trends in the business. The P&L may also be tracked in line with the budget to determine which areas of the business are over or under budget. It is also good to track certain expenses month to month to see if there are upward or downward trends that are cause for concern. If your cost of goods sold is continuing to increase month after month over a period of time you may need to dig in to understand what may be affecting those increases.
Gross Margin – the difference between the cost to produce or purchase an item, and its selling price. For example, if it costs you $100 to manufacture a product and you sell it for $120, your gross margin is $20.
It is important to realize that the gross margin (also known as gross profit) is the amount before deducting expenses such as selling, general and administrative (SG&A) and interest. In other words, there is a big difference between gross margin and profit margin.
Profit Margin – Net Income after tax / Net Sales. The after tax profit margin ratio shows you the percentage of net sales that remains after deducting the cost of goods sold and all other expenses including income tax expense.