In a previous blog I wrote about “accounting literacy” for small business owners. The starting point for any business owner in attaining accounting literacy is an understanding of the basic financial statements. In the next few postings I will provide a brief explanation of the basic financial statements – income statement, balance sheet and the statement of changes in position (Cash Flow Statement) – and cover the basics of how to read them and how to start to use them to help you run a better business. At Virtual BeanCounters, Inc. we work with our business owners during the first 30 days to make sure they have a clear understanding of what the basic financial statements are and how to read them. Next we build on that basic understanding, adding more reports and a more thorough analysis, so that eventually the business owner is spending a few minutes every day reviewing the appropriate financial reports to help them improve profits and cash flow. Use the financial reports to measure your business. What we measure we will manage, and what we manage we will improve!
Income Statement
The income statement is a document that reports on the flow of transactions your business has had over an entire accounting period, usually reported for a month, a quarter, or a year. The income statement is often referred to as a “profit and loss statement”, or simply “the P&L”. The income statement tells you the revenue the business has earned in the accounting period, the costs and expenses that were incurred by the business during the period and the net profit for the period – Revenues less direct costs less expenses equals net income or loss. The income statement is presented with revenue at the top leading down to the “bottom line” net income or loss, and usually consists of the following line items:
- Sales revenue
- Sales returns & allowances
- Other income
- Cost of goods sold (or direct costs)
- Operating expenses (selling, occupancy, general & administrative)
- Net Income from Operations
- Other Expenses (non operating expenses, such as depreciation and amortization, interest expense, income taxes)
- Net Income or Loss
An in-depth knowledge of accounting is not necessary for you to use the income statement to help you keep your business on track. We recommend looking at your financial statement in the 13 column format – for the twelve month period ending with the most recently closed month, with each of the twelve months reported separately in a column, and the 13th column representing the total for the year period. In my opinion, for management purposes it does not matter if the most recent 12 months is your actual fiscal year or not, it always brings things into perspective when you look at the most recent 12 months. This presentation is something your accounting and finance division should be providing to you every month, and will assist you in spotting trends, such as
- Are sales increasing, decreasing, or holding steady? This is usually the first thing on most entrepreneurs’ minds, so use the income statement to help keep tabs on it.
- Are your gross profit margins improving or not? If sales are increasing let’s make sure that those sales are profitable sales that meet our minimum profit margin requirements (more on that in a later blog).
- Are there any trends to spot in our expense line items? If there is a spike in a particular expense is there a good reason for it? Is every line item increase in expenses justified?
- If selling expenses are increasing are we experiencing a proportionate increase in sales?
These are just some basic questions you should be able to answer when analyzing your income statement, and once you are in the habit of reviewing your income statement in a 13-column format you will begin to identify and ask some more complex questions specific to your business. Ask your finance and accounting department to provide you with the 13-column income statement every month, it should be part of your minimum expectations of them. If they are having hard time meeting these minimum expectations in a timely and accurate fashion, perhaps it’s time to look elsewhere for help.
