Sections of the Income Statement, How They Work Together To Create Gross Profit and Net Income Using Costs and Expenses
We’ll start with a high level overview of the profit and loss statement, including the different sections of a profit and loss statement, what the major line items are in the profit and loss statement, and then we’ll get into the different ways that you can analyze your income statement.
First we see that we have January through September for the income statement. As I mentioned before an income statement is going to be over a period of time, a period of time can be one day, one month, one year, 10 years, the life of the business anything, generally what we see, though, is that the most useful form of a p&l or income statement is year to date with a breakout monthly, so we have that here. We have January, February, March, April, May, June, July, August and September broken out.
How We Get This Data – Closing The Books Each Month
Now, why don’t we have October. So, the process of books is that they have to be closed after the month is over. In order for us to report them to the financial statement, in order for that to happen your accountant or bookkeeper needs to make sure that every transaction that was logged in your accounting software usually QuickBooks or zero, went to the right, account.
What Are Accounts in a Financial Statement?
An account is where you can store and sort transactions that occur in your business. Remember how we said we could think of a business as the sum of all the tasks in the business that are completed? You can think of the financial statements as a record of all the transactions that occur in a business (cash and non-cash) that happen over a period of time.
In this theoretical business, we have three revenue accounts. Then we have a couple of costs of goods or cost accounts. And then we have some expense accounts along with some other accounts down below. We’re going to get into those in a second but the way that a P&L usually starts is with the income at the very top.
Cash Vs. Accrual Basis
Now, income is kind of tricky. Some people have heard of the term revenue recognition, but basically books can be in one of two forms, they can be in cash basis or accrual basis. Cash basis is what the majority of small businesses use. This means that a business will recognize that it has revenue when cash hits the bank. Now, that’s okay, that works, but the proper way to look at an income statement is through the accrual basis which means that as soon as the revenue has been recognized it goes on to the income statement and that doesn’t necessarily mean that you have received the cash yet. For example, if you do a bunch of work for somebody, but they haven’t paid you yet, you’ve technically earned and can recognize that revenue, even though they haven’t paid you. Maybe they have terms like net 10 or net 30. This P&L has been done in the accrual basis which means that we are recognizing revenue once we’ve earned it, not once we’ve collected the cash.
The first revenue account we have is project revenue and then we have monthly services revenue and then we have other income. Now why do we have multiple revenue accounts?
Why Have Multiple Revenue Accounts?
The reason we have multiple revenue accounts is that you often want to break up your revenue, depending on what kind of visibility you want into the business. For example, in this service business, we have two different types of work that we do for clients. We have project work and we have a monthly retainer that other clients are on.
Now, why did we break those up? Well, if you think about it and you’re a business owner of a professional services business, you probably want to keep track of the type of revenue that you’re getting that’s recurring on a retainer or some sort of contract, and you want to keep that separate from project work which is more of a one time thing. How you break it up in your business, whether you put one revenue account above another kind of depends on the logic of the business.
In this business for example, what we’re going to decide is that project revenue is usually a lead into people becoming a monthly service client or getting onto a contract with us. We consider Project Revenue to be at the top of our revenue funnel. We consider our standard recurring business as a little bit more stable and sustainable, and ultimately easier to forecast. For monthly contracts, it’s a bit easier to determine what sort of additional hires and other fixed costs we’d want to bring on in the future.
We also have an Other Revenue account which you’ll see in a lot of businesses. The reason we have this account is that occasionally we’re going to do work that doesn’t necessarily fall into the bounds of our normal work but isn’t completely out of scope. It’s not something that would never happen it’s just something we maybe don’t do that often. We like to have a bucket for other revenue that maybe doesn’t fit in our normal lines of business. And this is here in the 4900 other income account.
We also have this line called total income, which is where we sum up all of our different revenue accounts. We can see how these go month by month, and we’ll get into some of the horizontal and vertical analysis in a bit so this is the top of your Income Statement.
Direct Costs, COGS, or Cost of Goods Sold/Cost of Sales
Below revenue accounts and total Income, you’re going to have your COGS or Cost of Goods Sold, Cost of Sales, or direct costs. Different people call it different things, but it’s really important to know that there are two types of ways that you spend money: costs and expenses. Costs are basically things that are associated with the delivering of your product. Since we’re a service business. We’re going to say that we have some sort of labor associated with services that we do provide, and we have labor that’s associated with our project revenue and labor that’s associated with our monthly contracts, so we’re going to call those costs of goods sold or costs of service.
So we’ve got our direct costs and within this business we have two types of direct costs. We have employees that we hire who pay regularly. They’re on either a salary or some sort of hourly wage and then we’ve got contractors which are people that we do 1099 with. These are contractors that we bring in for a project or for extra help when we need it. We bring them in at a certain rate, and we like to break out those two different types of costs because contractors can be slashed almost immediately, whereas our employee costs don’t scale as directly; we don’t just hire and fire people. So we’ve got our cost of goods sold from summing up your direct costs. When you subtract that from your total income account, you get what’s called gross profit.
Gross Profit – How Efficiently Do You Service Your Customers?
We talked a lot about the efficiency of a business with gross profit in part I. The way we think about gross profit is that it is the number of dollars left over after you service or earn the revenue that you’ve generated in your business. This is the cash left over after you’ve paid for all the labor required to say, “Okay, I have fulfilled my obligation to the client. This is now earned revenue.”
The gross profit is what you have left to cover your operating expenses. Gross Profit is also where you decide how efficient your business is for it’s industry and compared to it’s competitors. Each industry is different, so in a grocery business or manufacturing business you have very small gross profit because there’s a ton of expenses, and it’s more of a volume business. However, in the professional services business that I have laid out, gross profit is going to be a lot bigger. It’s going to be more as a percent of revenue because there are less fixed costs and our labor is somewhat scalable.
Expenses, OpEx, or Overhead
COGS are separate from expenses. Expenses apply more to the overhead of the business that can’t be directly tied to one specific type of revenue. For example, your rent is going to be the same regardless of whether you have 10 clients or 30 clients that month. Rent is an expense that applies to the overall business so it’s going to sit down in our operating expense accounts which we often refer to as OpEx.
After you’ve got your gross profit, it’s time to look at your operating expenses. These are also referred to as overhead, and generally, it’s assumed that these things are relatively fixed or have what’s called a step functionality to them. Rent is relatively fixed – it goes up every year and that’s called a step function. Your people cost are a little bit more stagnant as well. If you have a CEO in your business, you’re not going to hire two more CEOs just because your company doubled. Your one CEO may get paid a little bit more but you’re not going to get more of those. You may have one marketing person or maybe you hire an additional marketing person every time you want to ramp your business by another 30% or 40%. Generally, operating expenses don’t scale directly in proportion with your revenue, which can be a good or bad thing. We sum those up and we get total expenses. And after we subtract our operating expenses, out of our gross profit, we get net operating income.
Net Operating Income
Net Operating Income (NOI) is the amount of income that’s left over after we’ve paid all of our costs, and we’ve paid all of our expenses incurred in the period we are referencing. This technically is what is left over in the business, after all that revenue has been recognized and all of our costs and expenses associated with that revenue have been paid. There are other expenses that a business incurs which is why we call it net operating income and not net income or net profit.
Below NOI, we have other income and other expenses. These exist because sometimes there are onetime events that occur which create income and create expense. For example, let’s say you own some land or you owned a building as a business and you decided to sell it. That’s not the line of business that this professional services firm is in. We would categorize this transaction as Other Income because we have to recognize that it happened but we also know that it’s not going to occur again or is it isn’t likely to occur again. You want to have the Other Income and Other Expense bucket here for these one time things that create expenses and income for you.
Interest Expense – But Not Principal Payback on Debt
Finally there’s this one other line here called interest expense which I want to talk about briefly. Interest expense shows up below your net operating income, but it is an expense to the business, and it’s the financing costs of the business. If you took out a loan in order to start your business or to grow it, the interest expense is going to show up on your P&L and affect your net income.
It’s called interest expense because we don’t book the principal payment of the repayment of that debt on our p&l. Principal paydowns show up on our balance sheet later. But the interest part the cost of the financing that we’ve taken on does affect profitability, and it shows up down here in this interest expense account. After we’ve got all of our other income and other expenses and we cancel out the other income and other expenses, that gives us our total net other income.
Net Income – The Bottom Line – Or Is It?
Net Other Income gets subtracted from our net operating income to give us our net income. This is our bottom line, sort of. In most small businesses net income doesn’t tell the entire story. You still have to pay taxes on that net income, and oftentimes, owners take what’s called a draw, meaning instead of paying themselves a salary, they pay themselves some cash from the business’s balance sheet less regularly than if they were on a salary.
When it comes to selling your business or figruing out how valuable your stock is, then you need to do some other calculations to figure out something like earnings before owners compensation. However, the principles here are that if you haven’t paid yourself a living wage or what would be necessary to replace you, then we still need to pull that out of our net income to get to true “earnings” for valuation reasonins. However, if you are paying yourself a salary that would be commensurate with your value in the marketplace, that would show up in People OpEx. As a result, we would be able to say that this was actually the net income of the business
Overall Structure of a P&L or Income Statement
This gives us an overall structure of a P&L. We’ve got our income accounts. We’ve got our cost accounts and after we subtract that from income, we get gross profit. Then we have operating expenses – once we pull those out of gross profit we have net operating income. And then after that we take out our other income and other expenses to get our net other income. We take the net other income out of our net operating income to get our true net income or bottom line. That’s net income before tax. And that gives you the structure of an income statement.
In our next video, we will go over the different ways that we can analyze this income statement to pull some insights out of the business. There are generally two ways that we can do P&L analysis – vertical analysis and horizontal analysis. Horizontal analysis is looking across periods and vertical analysis is looking at one period as a percent of some base number. More in the next video, part 3.