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What Is An 'Income Statement'?

An Income Statement is a financial report that calculates a business' profitability. If the business manages an inventory or extends credit to customers, a simple cash flow analysis can be misleading.

In order to determine whether or not your sales are profitable, you need to be able to track which sales and expenses are related. By matching each sale with the expenses incurred in the process of making that sale, it’s possible to see if you’re making a profit.

Josh Kaufman Explains The 'Income Statement'

Cash is important, but it’s not the whole picture. Cash is not Profit, and Profit is what we’re after. It’s possible to have a nice, comfortable cash position for a while, but lose money with every sale.

Imagine a Retailer that buys products from a manufacturer on credit: they receive inventory, but don’t have to pay the manufacturer for 90 days. For three months, the sales roll in, and the retailer’s cash position grows and grows. To the untrained eye, things look great.

After 90 days, the manufacturer’s invoice comes due. When you total the cost of the products and the retailer’s operating expenses, you discover the truth: the company lost money, even though the cash balance looked great for three months. If the retailer doesn’t do something, it’ll eventually run out of money and close.

Businesses can’t exist without Profits for long.

The retailer’s error was relying on cash accounting without understanding the limitations. For many types of businesses, cash accounting is ideal: it’s simple and easy to understand. As long as you bring in more cash than you spend, and you don’t run out of money, life is good. I’ve run my businesses using cash accounting for years. I get paid immediately when I provide products and services, and I don’t have an inventory to manage. My business isn’t complicated, so my accounting and financial tracking don’t need to be complicated.

For other businesses, relying on a Cash Flow Statement isn’t enough. If the business manages an inventory or extends credit to customers, a simple cash flow analysis can be misleading. In order to determine whether or not your sales are profitable, you need to be able to track which sales and expenses are related. By matching each sale with the expenses incurred in the process of making that sale, it’s possible to see if you’re making a profit immediately, without unpleasant surprises.

First, the company must change the way it accounts for expenses. Instead of recording revenue when cash flows in, and an expense when cash flows out, the company begins tracking revenue and expenses on what’s called an accrual basis.

In accrual accounting, revenue is recognized immediately when a sale is made (i.e. a product is purchased, a service is rendered, etc.), and the expenses associated with that sale are incurred in the same time period.

Accountants call this the matching principle, and one of the primary jobs of an accountant is to match revenue and expenses as accurately as possible. This is harder than it sounds: an incredible amount of judgement is required, and ambiguous areas are common. (If you’ve ever wondered what accountants do all day, this is a big part of the job.)

The end result of this effort is an Income Statement, which is sometimes called a “Profit & Loss Statement,” “Operating Statement,” or “Earnings Statement.” Regardless of the label, the Income Statement contains an estimate of the business‘ Profit over a certain period of time, once revenue is matched with the related expenses.

The general format for an Income Statement looks like this:

Revenue - Cost of Good Sold - Expenses - Taxes = Net Profit

Income Statements are very useful: there’s a reason businesses go to the trouble of creating them. By matching expenses with revenue, it’s easier to look at the company’s profitability and make decisions that will improve the company’s bank account in the weeks and months to come.

That said, it’s important to recognize that Income Statements, by nature, include many estimates and assumptions. They have to: large expenses like equipment purchases may involve a huge cash outlay, but the Income Statement attributes a small piece of the expense to each sales period, a practice called Amortization. This practice helps match the expense to the associated revenue: looking at a huge negative cash flow statement for that period would be misleading.

The matching principle, for all of its benefits, introduces many sources of potential bias in the Income Statement. By changing when revenue is recognized and how expenses are matched to that revenue, accountants and finance professionals can make the “profit” line skyrocket or implode by changing a few assumptions or formulas.

Exploring every source of potential bias in the Income Statement is way beyond the scope of this book. If you’re interested in more detail on this topic, I highly recommend reading Financial Intelligence for Entrepreneurs by Karen Berman and Joe Knight.

If you suspect your business needs accrual accounting to generate an accurate Income Statement, don’t do it yourself: talk to a CPA/CFA as soon as possible. The more accurate and reliable your Income Statement is, the better you’ll be able to manage your business: money well spent.

Questions About The 'Income Statement'

• Do you have a current Income Statement?
• If not, can you create one?

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"When I was young, I thought money was the most important thing in life. Now that I’m old, I know it is."

Oscar Wilde

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