An Income Statement is one of three major financial documents that are used in the business world. The others are the Cash Flow Statement and the Balance Sheet.
An income statement is also known as the "Income and Expenditure Statement" or the "Profit and Loss Statement". It is a summary of what income your business has earned, and what expenditure you have made, during the last month or year, or whatever period you want to review.
Where the Balance Sheet shows the solvency of your business (are your assets more than your liabilities), and the Cash Flow Statement shows the liquidity of your business (do you have enough cash to pay the bills and salaries), the Income Statement shows you how much profit or loss you are making.
As part of a business plan, an income statement is made up of estimated income and expenditure. Such a forecasted income statement is essential to draw the working budgets for your business from.
It is therefore a critical tool to check whether you are making a profit, and to see where your money is going.
All businesses have to prepare an income statement as part of the annual accounts. However, income statements can be prepared at any stage during the financial year, covering any length of time. Representing the difference between your revenues and your expenses, they are able to show your 'bottom line' very starkly.
The difference between an income statement and a cashflow statement
The main difference between an Income Statement and a Cashflow Statement is that Cashflow deals with cash only, not with money owed to your business or money that your business owes someone else.
In practice, this difference boils down to the following:
- When you sell something on credit to someone, it is immediately recorded in the income statement, but not in the cashflow. Only when the cash comes in, is it recorded in the cashflow.
- When you buy something on account, it is immediately recorded in the income statement, but not in the cashflow. Only when you actually pay for the item, is it recorded in the cash flow.
- Only the interest payment on a loan is recorded in the income statement, not the part of the installment that goes towards repaying the capital amount of the loan. In the cashflow, however, both the interest portion and the capital portion of a loan installment is recorded.
- Depreciation is recorded in the Income Statement, not in the Cashflow. This is the amount of value that your equipment and machinery loses every month. Because it is not cash flowing out, the cashflow statement does not deal with it at all. The only time the cashflow comes near to depreciation is when you actually pay for a new machine to replace an old one. The Income Statement, however, deals with the slow depreciation of equipment because it is real value that your business uses, even though you don't actually spend the money every month. It therefore has a real influence on profit and loss
Outline of an income statement
The income statement shows:
- The sales, on credit and cash, for the period;
- The expenditure, in cash and on account, for the period; and
- How much profit there was in that period.
You can also include the figures for the previous month (alongside the current month) to give you a picture of whether you are spending/earning more or less than before.
Income statements are generally set out in the way illustrated below.
- Sales figure. The sales figure shows the actual sales for the period, excluding VAT. It does not reflect the cash received from customers, since some payments may still be outstanding. A basic principle in accounting is to match costs against the revenues generated by those costs, so it is important that the sales figure is correctly calculated. It should be the sum of all invoices generated rather than paid during the period.
- Direct costs. The direct costs, those costs directly attributable to the sales, reflect raw materials and sub-contract costs in the product or service actually sold during the period. In most businesses (except retail), employee costs can also be directly attributed to the product sold. There may be stock purchased during the period that was not consumed (ie. stock in hand at the balance sheet date); this will be shown on the balance sheet but not charged to the income statement. Conversely, raw materials may have been consumed which were bought in a previous period. The cost of those materials will be included in the direct costs. Materials purchased but not consumed will be shown in the stock figure on the balance sheet. It is important to watch out for purchases of materials or sub-contract work which have gone into sales made during the period or included in stock at the period end, but for which the business has not been billed. This applies to any costs incurred where invoices have not been received. Ideally, the business will not prepare the accounts until all bills have been received. However, when producing management accounts, an estimate of these costs may have to be made in order to give a profit figure that is as accurate as possible.
- Profit. The direct costs are deducted from the sales figure to give gross profit. This allows the business to calculate its gross profit margin. The overheads are deducted from the gross profit to give the net profit. It is important to keep an eye on both the gross profit margin and the net profit margin. Dramatic reductions in either could be a sign of trouble.
- Depreciation. The depreciation element in the income statement does not involve a movement of cash. Depreciation is included to cover the wear and tear of fixed assets. The amount included therefore is an allocation of the cost of fixed assets over their useful life. If depreciation is high relative to payroll costs, the business is capital intensive; if the payroll costs are high relative to depreciation, the business is labour intensive.
- Appropriation account. It is usual at the bottom of an income statement to explain how the profit is divided; this is termed an 'appropriation account'. Profit can be divided in three ways:
- To the shareholders or owners (as dividends or drawings);
- To the government as tax; or
- Retained in the business (to use as working capital or to buy equipment or other assets).
Helping you spot business problems
The income statement is particularly useful for this sort of problem:
- If there is concern regarding excessive overhead charges, it is useful to refer to the income statement as it gives a breakdown of each individual type of expense.
- By drawing up an income statement, it is possible to see whether corrective action is needed to maximise profit. For example, it may show that the percentage of raw materials as a proportion of sales is too high.