An income statement is the financial story of your business—a monthly, quarterly, or annual tally of revenue minus expenses. It’s also called an “earnings statement” or a “profit-and-loss statement.” It answers the question, “How profitable is your business?”
Yet it’s a mystery to many entrepreneurs, even as public companies must publish the details of their income statements quarterly. (Apple, for example, made $32.3 billion in gross profit in Q2 2021.)
Other companies have exploited outsiders’ perception of corporate finance as a black box. Enron, infamously, conjured revenue from projections, made losses vanish from its books, and touted a too-good-to-be-true income statement that many believed for far too long.
These are outliers—not reasons to be intimidated. We’ll help you put together your first income statement.
The key components of an income statement
An income statement is usually compiled monthly, with monthly numbers tallied for quarters and years. Why monthly? Because one goal of an income statement is to keep a steady pulse on your business—to identify dips (or spikes!) when they affect a quarterly growth goal, not business solvency. To create an income statement:
- Start with sales revenue (physical products or services). You may have more than one revenue stream.
- Subtract the cost of goods sold (COGS). Costs include finished products, raw materials, labor, etc. (some service products may also have costs).
The resulting number is your “gross profit.” From that number, subtract expenses for:
- Marketing and sales (e.g., Google Ads campaigns, trade show booth)
- General and administrative (e.g., salaries, office space, warehousing)
If your business is divided into departments or has unique expenses (e.g., industry-specific research), you may subtract those as line items, too.
The resulting number is your EBITDA, or earnings before interest, tax, depreciation, and amortization. It’s your gross profit minus expenses.
Income statements sometimes separate operating from non-operating revenue and expenses to keep one-off gains or losses from distorting the financial picture of the business. The “right” level of granularity depends on who’s looking at your income statement and for what purpose.
From your EBITDA, subtract:
- Depreciation and amortization expenses (e.g., portions of big-ticket items).
Now you have your “operating income,” which is also called your earnings before interest and tax (EBIT).
The final steps for your income statement tackle the remaining letters in the acronym:
- Subtracting interest paid or adding interest earned, which gives you your EBT (i.e. pre-tax income).
- Subtracting income tax paid on your EBT.
The result is your net income or net earnings—the bottom-line number on your income statement. It’s also the first step in creating two other financial reports.
Income statements vs. balance sheets
If companies had vital signs, the income statement would be one. The balance sheet and cash flow statement are others; each offers a different vantage point of the same financial landscape. Combined, the three assess a company’s financial health and inform financial forecasts.
The most confusion comes when comparing balance sheets and income statements. A few key differences help clear things up:
- Balance sheets are a snapshot in time (e.g., “as of October 15, 2021”); income statements are summary metrics for a longer period (e.g., “for Q3 2021”).
- Balance sheets weigh assets against liabilities instead of revenue against expenses.
- A balance sheet’s summary metric is “owner’s equity” instead of “net income.”
Balance sheets help answer the question “How much is this business worth?” instead of “How profitable is this business?” The former is a question of business solvency; the latter is a question of business performance.
Valuable businesses aren’t always profitable, and vice versa. For example:
- A valuable company could be unprofitable for years. Think of high-growth startups using venture capital—not revenue—to expand.
- A profitable business may have huge liabilities looming ahead. Think of auto manufacturers and their underfunded pension plans.
A good, if imperfect, parallel is a government’s deficit (i.e., income statement) versus its debt (i.e., balance sheet). If, for now, you’re president of a one-person enterprise, not a nation state, you have a few more choices to make.
How to create the right type of income statement
Good accounting helps you understand how your business is doing. The complexity of questions you have—and the type of income statement that will serve you best—will grow with your business.
Even if you’re creating your first income statement, you have a couple choices to make:
1. Horizontal versus vertical analysis. A horizontal analysis uses absolute numbers for each metric—real dollar amounts (e.g., $40,000 in gross profit in 2021). Most outsiders peeking at your finances prefer a horizontal analysis because it offers actual numbers. It’s easier to spot big contributors to an increase or decrease in profitability.
A vertical analysis, by contrast, uses relative measurements—percentages of a base number (e.g., 30% of expenses came from marketing). A vertical analysis makes it easier to understand the relationships among items on your income statement. It’s also a useful tool for comparing yourself to industry peers or benchmarks.
You can use both analyses, adding a parenthetical percentage (for vertical analysis) to the right of a hard number (for horizontal analysis).
2. Single-step versus multi-step income statement. A single-step income statement is a single formula with a single summary metric:
Revenue – Expenses = Net income
Typically, revenue and expenses are single line items. For example, “revenue” may not separate sales from the COGS.
A multi-step income statement, like the one outlined at the start of this article, uses more line items and generates summary metrics from three sequential formulas:
- Sales – COGS = Gross profit
- Gross profit – Operating expenses = Operating income
- Operating income ± Non-operating items = Net income
A more complex process offers more granular visibility into your financial situation. As you can see, it gives you two numbers—gross profit and operating income—that a single-step process does not.
Gross profit shows the ability of your product or service to generate revenue, given the costs of production. Operating income assesses the efficiency with which you sell that product or service.
Do you really need those additional figures? It depends with whom you’re sharing them.
Know who needs the information—and why
You’ll probably create your first income statement for an audience of one: you. If a line-by-line breakdown of the minutia is more confusing than illuminating, your income statement isn’t doing its job.
One way to build a statement that will work: start with the basics and catalog follow-up questions, from you or others. Then, identify where a more detailed section—like a breakdown of marketing expenses between online and offline events—could proactively answer those questions.
If you’re looking for a loan or to raise capital, you’ll need to include more details and, almost certainly, create a multi-step income statement. Lenders and investors want to know, for example, whether your gross profit is enough to sustain a positive net income as you scale (and incur more operating expenses). A tiny margin may make a one-person shop profitable; it may not work for a company of 20 or 200.
Outside funders will also compare your business to others, an insight you can take advantage of too. Through public company filings, industry benchmarks, networking events, or casual conversation, understanding your income statement will help you speak the same language as your fellow founders.
You’ll know how you compare, where you’re succeeding, and what to work on next.