What is an Income Statement?

The income statement is one of the key financial statements that businesses produce. It provides an insight into a business’ performance as it allows the user to see a business’ revenue, expenditure and profit (as well as much more).

The income statement is often referred to as the “profit and loss account” or in many cases, simply “the P&L”.

Although there is a lot of information to be found in the P&L, interpreting this information is quite straight-forward and we will break down the main sections of the income statement so you know what to look our for.

What is the Purpose of an Income Statement?

Before we dive into the detail, we need to understand what the point of an income statement is.

To put it simply, the purpose of a profit and loss account is to show how much profit a business is able to generate from it’s day-to-day operations. It is worth noting that an income statement doesn’t just show profits – if a business makes a loss this will also be seen on the income statement (again, this is why it is sometimes called the profit and loss account).

The P&L provides its users with an outline of how much money the business generated from its sales, how much the sales cost the business to make (normally the cost of the goods that were sold) and then the general running costs of the business to find out the net profit position.

What is the Layout of an Income Statement?

In order to be useful, all profit and loss accounts must follow the same format so that they can be easily interpreted by anyone who understands financial statements.

The layout of a basic income statement should be as follows:

Note that when producing P&L’s (or any other financial statement for that matter), we use brackets to indicate that a number is negative. In this example profit and loss account, brackets are being used to show that one number is being taken away from the other.

For example, operating expenses are shown in brackets as they get taken away from the gross profit.

Let’s have a look at each item in more detail.

Revenue

Since revenue is always the first item on an income statement, we need to make sure we understand this before anything else!

Revenue is simply the value of all sales the business made in a certain period.

For example, if a business sells TV’s for £200 each and they sell 5 of these in a year. The P&L account for this year should show £1,000 in the revenue figure.

Revenue can also relate to the sale of services. This could be providing consulting services, washing cars or cutting hair.

Either way, the revenue figure should show all the sales made in the year.

Remember!

Sales made and cash received are not the same thing!

If the business sold those 5 TV’s in the last month of the year and the customers had all agreed to pay in the following month, the revenue figure should still show £1,000!

This is because the business still made the sale whether the customer paid or not.

This is a key accounting concept that you will need to understand when generating an income statement and is known as the “revenue recognition point”.

We have an in-depth guide to revenue recognition which can be found here.

The guide goes into much more detail about when revenue should or should not be included in the P&L but essentially there is one key rule to keep in mind:

Revenue should be included in the income statement if the related goods have been delivered or the service has been provided to the customer.

Revenue may also be known as: Income, Turnover or simply; Sales

Cost of Sales

The cost of sales figure is the first expense figure that appears on the P&L.

The name of this item pretty much explains what it is: the cost of all the sales made in the year.

Let’s go back to the example of the business that sells TV’s. Even though they sold 5 TV’s for a total of £1,000, the TV’s will have cost a certain amount of money to purchase in the first place, before they could be sold on.

If each TV cost £100 for the business to buy the the total cost of sales would be £500 (5 TV’s X £100 per TV).

Similar to revenue recognition, we must only include the cost of goods which were actually sold in the year.

Most business will keep goods in stock so they are ready to sell when a customer makes an order. Therefore, the example business may have bought 10 TV’s, but only sold 5.

Only the cost of the 5 must be included in cost of sales as these were the only ones that were actually sold.

You can’t have a cost of sale if the item wasn’t sold!

This may seem pretty obvious, but it is easy for people who are new to accounting to make this mistake simply by putting the cost of all purchases in the “cost of sales figure”.

Next Step: Calculate the Gross Profit

Now that we know the revenue and cost of sales figures, we can calculate the gross profit.

Gross profit is a term used frequently in the business world as it is a good indicator of the potential of a business. Gross profit is simply the money that is left over after each sale is made. These leftover funds are used to pay the general running expenses of a business.

Therefore, if a business only generates a small amount of gross profit this can be a sign that the products it sells simply are not enough to keep the business running.

If a business makes a high amount of gross profit this is a good sign! The products it sells are capable of generating plenty of funds to run the business and as long as it keeps its other expenses down, the business should be successful in the long-term.

How is it Calculated?

Calculating the gross profit figure is easy, we simply follow the below formula:

Revenue – Cost of Sales = Gross Profit

It’s as simple as that! Take the cost of sales away from the revenue figure and this will give us the gross profit for the period.

When the gross profit has been calculated we can then use it to analyze the business through the use of ratio analysis. Gross profit is used in some of the key accounting ratios such as gross profit margin and mark-up.

Operating Expenses on the Income Statement

The next item on the income statement is operating expenses.

Operating expenses is a term used to describe all the general running costs of the business that are not related directly to the goods being sold (as these have already been included in the cost of sales figure).

This item usually contains a large number of items grouped under the heading “operating expenses” simply because business tend to have many expenses that are required to keep their business running.

What is Included in Operating Expenses?

Operating expenses is a broad term and can include (but not limited to) the below:

• Building Rent
• Electricity
• Heating
• Fuel Costs
• Wages/Staff Costs
• Advertising/Marketing Costs
• Business Rates
• Broadband/Telephone Charges
• Insurance

These are just some of the expenses that fall under this category.

The rule of thumb is that if the expense does not relate to the direct sale of goods, it should be categorized as an operating expense.

Operating expenses may often be referred to as administrative or “admin” expenses. These terms are used inter-changeably so do not be confused if you hear them being referred to as one or the other!.

Key Accounting Concept: Accruals

Before we go any further, we must understand another key accounting concept: Accruals

Much like with revenue, expenses must only be included on the income statement if they were actually incurred in the period.

However, with accruals the misconception usually occurs the opposite way around.

People have a tendency to think that if they haven’t yet paid for an expense, they don’t need to include it on the P&L.

This is not true. In fact, it is absolutely vital that expenses are included even if they are not paid for yet because if they are not, the income statement will not provide a true reflection of the business operations.

For example, say a business pays rent on its building on an annual basis. The payment is made at the end of march every year but the businesses year end is 31st December.

This means that at the end of every financial year (when the income statement will be produced) the business has used 9 month’s worth of rent but has not year paid for it.

Therefore, we use accruals to ensure that this 9 month’s worth of rent does get included in the income statement – even if it has not yet been paid for.

For a more in-depth guide on accruals, please see this guide.

Calculating the Operating Profit

Now that we have calculated the total operating expense figure (included any expenses that have been accrued for), we can calculate the operating profit.

To do this we simply subtract the total operating expenses from our gross profit:

Gross Profit – Operating Expenses = Operating Profit.

What Does this Show us?

Operating profit shows the user the funds the business has left over after covering all of its necessary expenses. These funds are then used to cover the following expenses:

Interest Receivable/Payable on the Income Statement

Interest receivable and payable are the first expenses we have come across in this guide that don’t exactly relate to the business’ everyday activities. In reality most business have very little interest receivable but it is still important to understand what this is. It is more common for an interest to have interest payable and we will discuss this further below.

• Interest receivable – This is the amount of money the business has earned through its investments/savings. For most small businesses this is simply the interest earned on the funds they hold in their bank account (which is normally relatively small). For some larger businesses with a large investment portfolio, interest receivable may be much higher but generally businesses tend to have a small amount of interest receivable.
• Interest payable – This is the amount of interest due on the business’ borrowings. As most businesses tend to have some form of borrowings (bank loans for example), it is much more common to see interest payable shown on the income statement.

If a business does have both of these items, they must show them separately on the profit and loss account. They can not “net them off” which would mean taking the interest payable away from the interest receivable and showing this as one figure.

This section of the income statement may also be known as the “finance costs” section as it shows the costs associated with how the business is financed. This section has no relation to the day-to-day operations of the business and this is why it comes after the “operating profit” section. If we look at our example of the TV business – it may pay £800 interest on a loan each year but this has nothing to do with the cost of the TV’s it sells.

Profit Before Tax

Profit before tax, or PBT as it is commonly abbreviated to, is one of the key numbers on the income statement. It is the total amount of profit a business makes before corporation tax is taken away from it. Since corporation tax is a cost that cannot be avoided, profit before tax is a good indicator of how well the business performed in the period.

The calculation for PBT incorporates all the sections of the P&L we have looked at so far. To calculate it we do the following:

1. Take the operating expenses away from the gross profit to find the operating profit.
2. Then, add on interest receivable / take away interest payable to find the profit before tax.

Calculating the Net Profit

This is the final step required to complete the income statement.

Once we have arrived at the profit before tax we simply need to take away the tax charge to find the net profit.

As of January 2021, the main rate for corporation tax is 19% – per HMRC.

Calculating the tax charge can be highly complex as we may have to incorporate different allowances and exemptions into the calculation as well as deferred tax amounts.

As a general rule of thumb the tax charge will be around 19% of the profit before tax, but it may be necessary to have a tax specialist look into this charge and ensure its accuracy.

Once we know the tax charge we simply subtract this from the profit before tax and this will give us the net profit.

What is Net Profit?

Net profit is the final amount of profit after EVERY expense has been deducted. Essentially this is the amount of money left for the business owners to re-invest or withdraw from the business.

Net profit may also be used to pay dividends to a company’s shareholders if applicable.

Net profit may also be called profit for the year or profit for the period, lets have a look into why this is:

When is an Income Statement Prepared?

An income statement is normally prepared at the end of a business’ financial year. However it is important to understand that an income statement can be prepared for any period you wish (one day, one week or a month for example). Although creating an income statement for just one day is not common at all!

For this reason you should always title your income statements in a particular way. The format for this is as follows:

Income statement for the year ended 31/12/20XX

or if the P&L is for less than 1 year:

Income statement for the period ended 31/12/20XX

The important point to take away from this is that income statements are always made to cover a period of time unlike a balance sheet which is only prepared for a certain date.

Summary

You should now have an understanding of :

• What an income statement is for
• What the layout is
• How to perform some of the key calculations
• An understanding of the important accounting concepts such as revenue recognition points and accruals
• How to title an income statement

Keep up to date with our latest posts if you want to learn more about income statements and double-entry bookkeeping!