It is important to know what is an income statement because it tells you what goes into a business so that we know what can go back out while still ensuring success, and thus the income statement is a strong testament to the viability of an organization.
When it comes time to pay our taxes, personal forms are relatively straightforward, but for business, the income statement is essential to provide the more detailed and advanced information required of business taxes. The two most central means of tracking and presenting a business’ finances are those of the income statement and the balance sheet. A balance sheet is in effect a snapshot in time of all the finances and obligations of an organization while the income statement tracks the ins and outs of money for a business over time. Following is a presentation of the income statement to highlight its essential nature.
Why Is It Important?
Central to the question of what is an income statement is why it matters. The income statement is a financial statement that reports on the financial performance of an organization over a particular period of time. Often income statements are annual and track the fiscal year of an organization although they are also often constructed quarterly or even monthly to provide management with insight as to the income being realized by the business.
The income statement is a central piece of information on a business that is used to inform the strategic imperatives and practices of management, who should not be managers if they cannot fully answer the question "what is an income statement". The essential purpose of any business that is a for-profit is to achieve income in excess of expenses to in turn general a positive financial outcome, and thus the income statement is of particular importance for any business.
Without the effective tracking of income, the investments and expenditures that a business must make cannot be made without fear of going into the red. The effective management of the inputs and outputs of an organization are the keys to success. Without effectively tracking income, our businesses would be working in the dark financially, and success or failure would be just as likely to be realized.
Accuracy Equals Success
The effective and accurate tracking of all revenues and expenses for an organization is the lifeblood of success for any organization. When considering opportunities for expansion, it is essential to know what comes in and what goes out, on average, to plan effectively for the future. Through accuracy in financial reporting, an organization is able to measure its current degree of success, and prospects for the future through which success might be better supported and ideally expanded upon.
Measuring Profit and Potential
The income statement is the primary instrument through which the profitability of a company is measured. Profitable companies bring in more than they put out, with the difference having the potential of being re-invested into the company, or distributed to its owners and/or shareholders. The purpose of the modern corporation is to generate a profit, and when the corporation is publicly traded, this focus upon maximizing the profit to optimize the return to the shareholder is central to the structure of a business. Without profit, an organization cannot survive, and without the income statement, profit cannot effectively be measured.
A key factor of the income statement is the gross profit statement. The gross profit is the revenues realized through the sale of goods or services, less the cost of those goods or services. The gross profit provides a barometer for the financial health of a company although does not effectively encompass all costs that a company will face.
The gross profit does not show other expenses that are undertaken by the company to realize their revenues, such as marketing and advertising, which for some products can drastically outweigh the actual cost of production. Think Coca-Cola, while carbonated sugar water is cheap to produce, achieving a globally recognized brand is rather costly.
Having established the expenses associated with the production of the organization’s products and services, the next element of the income statement is operating expenses. The accurate and careful calculation of the operating expenses is achieved, then subtracted from the gross profit. The remaining amount is the bottom-line of the income statement and represents the profit if positive of the company or loss if negative.
When there is a negative number on the income statement, the company did not produce a profit during the period being assessed. However, not all companies must achieve a substantial profit to maintain, and for innovation-based organizations, profit may not be realized for many years until the organization has progressed through research into sales.
Having highlighted the essential nature of the income statement, we’ll now turn to how to prepare it, so that when asked “what is an income statement,” we’ll quickly know the answer, and after, how to perform one.
How to Prepare an Income Statement
Now that we’ve learned the basics and can answer the question “what is an income statement,” we are ready to move on to how to prepare one. The income statement is also referred to as a profit-and-loss statement, in which revenues and expenses are explored in-depth. Thus, to begin the numbers of the organization’s operations must be assembled. All monies going in, and all monies going out, of the organization, must be collected and organized into presentable data.
To explain what is an income statement, we must know what revenue is. First, we’ll focus on the revenues of the organization. Revenue is the inflow of cash that is achieved through sales, interest or any other form of investment that results in a return. The effective tracking of the revenue of the organization at all times is essential. All sales, no matter how minor or negligible, must be built into the income statement in the form of revenue. Spreadsheet software such as Excel is useful to provide for the organization necessary to provide an accurate and comprehensive information on the revenue statement.
Having added up all the income of the organization from all possible means, the revenue of the organization has been established. The total net revenue of an organization must exceed its expenses for the organization to maintain profitability. To measure this level, we must now turn to the expenses of the organization to add them up and determine whether they fall under, meet, or exceed the revenue of the organization. Expenses are outflows of cash, whether to pay employees, cover the cost of rent, purchase raw materials for production, or for essential support services such as accounting.
The total expenses of an organization must be carefully assessed and tracked to ensure that revenues are sufficient to cover costs. For whatever accounting period is being assessed, all outflows of cash must be accounted for. All operating costs are included in this ranging from rent to materials as well as for human resources. It can be ruinous for an organization to track ineffectively its expenses, and so the maintenance of records and storing of all receipts is essential to provide accuracy, and the ability to double-check if there are any questions.
Sometimes measuring the outflow of cash is complicated by the concept of “amortization,” in which the initial cost of a necessity is spread over the amount of time that item is to be used. For example, if a piece of equipment costs three dollars and the equipment will be used for a period of three years, its cost may be amortized by expensing one dollar for each of the three years that it will be in operation.
Operating Versus Non-Operating Costs
Within the context of the income statement, it is traditional to break up the statement into both operating and non-operating portions. The operating element of the income statement presents information concerning the revenues and expenses that directly result from regular business operations. These include sales and rent for example, with sales often being the primary source of operating revenue while rent and human resources are often the most significant costs realized by organizations. Recognizing the sources of operating revenue and costs is essential to the income statement’s integrity.
Non-operating costs are the revenues and expenses that are not directly tied to the operations of the organization. Auxiliary costs and investments undertaken on behalf of the organization may be listed in this area, such as interest earned from investments, costs associated with exploring business expansion prospects, and other such areas.
What is an income statement? Well, we now know a great deal more than when we began. The income statement is the means through which the success of an organization is tracked by accounting for the sources of income that the company holds, and the demands placed upon the company in terms of expenditures. Without effectively generating income statements at regular intervals, the financial health of a company is unknown, as would be its ability to weather difficult times or to take advantage of prosperous times by expanding.
Whether your asking what is an income statement or trying to learn more about other essential elements to support the management of your financial health, check back to Finance for Dummies.