The Income Statement: How to Read Your Profit and Loss Report

What the statement contains

Revenue at the top, then cost of goods sold, gross profit, operating expenses, operating income, other items and net income.

• Revenue: sales from products and services.
• Cost of goods sold (COGS): direct costs of what you sold.
• Gross profit: revenue minus COGS.
• Operating expenses: rent, wages, marketing, software, insurance and similar.
• Operating income: gross profit minus operating expenses.
• Interest and taxes: financing costs and income taxes.
• Net income: what remains, the bottom line.

A worked example

Revenue of $100,000, COGS of $40,000 and operating expenses of $45,000 leave $15,000 of operating income before interest and taxes.

Gross margin is 60 percent ($60,000 / $100,000). Net margin before tax is 14 percent. See how to calculate profit margin.

Profit is not cash

The income statement can show a profit while the bank balance falls, because it counts sales when earned, not when paid, and ignores loan principal and equipment purchases.

If you invoiced $30,000 this month but customers have not paid, revenue is up and cash is not. If you repaid $5,000 of loan principal or bought equipment, cash left the business but profit did not change. That is why you need the cash flow statement too. Read cash flow vs. profit.

Cash basis or accrual basis

Cash basis counts income and expenses when money moves. Accrual counts them when earned or incurred. The choice changes the statement.

Accrual gives a better match between revenue and the costs of earning it, which is why it is better for businesses with inventory or credit sales. Ask your accountant which you should use. Details are in cash vs. accrual accounting.

What to look for each month

Compare each line with last month, last year and your budget. Look for margin changes and expense creep.

1. Is revenue trending up or down?
2. Did gross margin move? If so, are costs or prices to blame?
3. Which expense lines grew faster than revenue?
4. Are one-time items distorting the month?

Percent-of-revenue views help, since they let you compare months of different size.

Keeping the statement accurate

Statements are only as good as the categorization and reconciliation behind them.

Reconcile accounts monthly and review uncategorized items. See bank reconciliation and expense categories. Close the month before you read the report, as described in closing the books.

Common income statement errors

Wrong categories, mixing loan principal with expenses, and recording revenue in the wrong period are the usual causes of misleading reports.

• Recording loan principal payments as expenses, which understates profit.
• Recording loan proceeds or owner deposits as revenue, which overstates it.
• Leaving personal spending in business accounts.
• Forgetting accrued expenses such as wages owed at month end.
• Putting direct costs in operating expenses, which hides gross margin.

A quick review of the biggest ten transactions each month catches most of these. If a number looks surprising, trace it back to the source documents before acting on it.

Using the statement when considering financing

Net income and margins show how much room you have to absorb financing costs while keeping the investment worthwhile.

If financing adds $2,000 a month in payments and the project adds $5,000 of profit, the math works. If your margins are thin, test a downside case. ROI Funder shows true cost, payback period and monthly-equivalent payments before you sign. We consider 500+ FICO, 6+ months in business and $20,000+ monthly revenue. See how much funding your business can afford.