To successfully use a Profit and Loss statement or Income Statement, you need to first understand the individual components. Only then will you be able to grasp the financial performance depicted in this statement as a whole.
Top line Revenues, sometimes referred to as Sales, come first. This represents earned sales you’ve made from your customers. Depending on the type of business you’re in, you could have multiple revenue categories such as Software and License Sales as well as Support and Maintenance Revenue. Breaking out your sources of revenue into different accounts or categories will help you see where your business is under/over performing and is a great tool for aiding in business strategy decisions. One common misconception about revenue is the assumption that it represents money you’ve already collected on sales. This is not always true. It is important that your accountant understands US GAAP revenue recognition principles so your revenues are not misstated. Again, depending on the type of business you are in and whether you use the cash or accrual method of accounting, you could have revenues that have been fully recognized yet no cash has actually been collected from the customer. This is an important distinction to understand as a reader of financial statements. Some of the best insight into understanding revenues for a particular business is to become educated on what the company sells and how they generate those sales.
Next, we have Cost of Sales or Cost of Goods Sold (COGS). Also very dependent on the industry, Cost of Sales represents the expenses incurred that directly relate to fulfillment of sales for your company. This can include the cost of materials associated with creating the goods to be sold as well as the labor costs used to produce the goods. If your company has inventory, COGS follows the ensuing formula: Beginning Inventory + Purchases – Ending Inventory = COGS. It is very important to classify your COGS correctly so you have an accurate picture of your Gross Margin.
Gross Margin comes next and follows the equation: Revenues minus COGS. This represents the resulting profit or loss made on fulfillment of your company’s sales. How much are we actually making on the sales of our product? These are the answers you will have by analyzing the gross margin assuming you properly recognized your revenues and accurately classified your cost of sales. You can also look at gross margin as a percentage of Sales (Revenues – COGS)/Revenues. In short, your Gross Margin is what you have left over to cover your Operating Expenses.
Following Gross Margin is Operating Expenditures (OPEX). OPEX, generally speaking, are all the other costs that are not classified as COGS. This includes: selling, general & administrative costs, rent, utilities, repairs & maintenance, depreciation, office supplies, administrative salaries/wages and payroll taxes, travel expenses, legal, advertising & marketing, and many others. At this point you can calculate your Operating Profit or Loss by taking Gross Margin – OPEX.
While OPEX is basically everything beyond COGS, there are a few things it does not include: items that don’t relate to normal business operations. This could be items such as rental income, interest expense on debt, or interest income on investments. These get placed into Other Income or Other Expense. The result is your Pretax Income or Loss: (OPEX + Other Income – Other Expense) and represents your businesses performance prior to paying taxes.
Income Taxes follow and thus result in your After Tax Performance: (Pretax Income or loss – Income Taxes). This is also the same as Net Income (loss) and can be referred to as the “bottom line”. This represents the culmination of all business activities: direct & operational as well as indirect and non-operational. So, how much money did you make or lose? Now that you understand how the Income Statement works, you can take a look at what modifications you can make to better classify your expenses , perhaps where you can cut costs, or how much you need to increase sales to improve your bottom line.Written by: Andrea Murray TGG Accounting