In this video you'll learn what an income statement is.
I'll show you what it looks like and how you can use it to
measure a business's financial performance.
[Music]
Hey there
welcome back to Accounting Stuff I'm James and in today's video
we're going to cover the income statement
also known as the profit and loss statement or the P&L
for short. This is one of the three major
financial statements in accounting along with a balance sheet
and the cash flow statement. Collectively these reports
give us an impression of a business's financial health
so it's important that we understand how they work.
I've already made videos covering the balance sheet and the
cash flow statement which you can find linked up here and
down below in the description. But up until now I haven't posted
a video yet on the income statement and I've received a lot of requests
from you guys to cover this topic so thanks for all these
particularly from one subscriber so Niloy, if you're watching
this video goes out to you good luck in your exam
hope you crush it! An income statement is the
summary of a business's revenues and expenses over a period of time.
In its basic form an income statement looks like this.
It's a summary of a business's revenues and expenses
over a period of time. When we take our total revenue and
subtract our expenses from it then we work out our profit or our loss.
We make a profit when our revenues exceed our expenses
and on the flip side we make a loss when our expenses
are more than the income we've earned. This is why the income statement
is also known as the profit and loss statement or the P&L
for short. It lays out a roadmap for how we
ended up here at the bottom line
our profit or loss. The income statement
always covers a period of time which could be anything that we
want it to be but typically we run it for a month
a quarter or a full year. Here's a helpful analogy
that I read in this book the accounting game
which I recommend reading if you're new to accounting
you can find my review of it up here. Anyway back to it.
If a balance sheet shows us a snapshot of a business's assets
liabilities and equity at a single point in time then you can
think of it as a photograph or a still frame taken from a video.
Whereas the income statement covers a period of time
it's like watching a clip of that video it has a beginning and it has an end
and if we look at it carefully and analyse it then it can tell us a story
but more on that later. Let's take a closer look at our
income statement. Revenues less expenses
make us a profit or a loss. The problem with this layout
is that it doesn't give us much detail it would be much better
if we made things a little more descriptive for instance
revenue there are many different types
of revenue. If we were running a business that sells
physical products then we might want to call this product sales instead
or if we provide services we can call this our services rendered.
This extra detail helps the readers of the income statement
better understand what they're looking at. Clarity is the aim of the game here.
The same goes for expenses businesses typically incur many
different types of expense but broadly speaking these can be
broken down into two categories our direct costs of doing business
and our indirect costs of running the business. Our direct costs of doing business
are the costs which we can directly trace through to the products
we've sold or the services that we've provided.
For a business that provides services we might call this our cost of services
and if we sell physical goods then we can call this our cost of sales
or our cost of goods sold. Direct costs like these are variable costs
which increase in direct proportion to the sales that we've made.
If you were running a retail or a wholesale business
then these would include things like the original purchase price
of the product that you're reselling or if you've run a manufacturing business
then this would include the cost of your raw materials
or the direct labor cost that went into producing your product.
As we make more sales we incur more of these direct costs.
Cost of goods sold can be a bit of a tricky concept to
understand at first. It ties in very closely with inventory
in the balance sheet. If you'd like to see me make a video
explaining how all of that works then let me know
down below in the comments and if you haven't already
remember to hit that subscribe button so you don't miss out on all of
the other accounting tutorials that we have coming out very soon.
Back to the income statement. When we take our revenue and
deduct our direct costs of doing business
we get to our gross profit. If you're new to accounting
then you'll soon discover that we have many different types of profit.
Our gross profit is a really useful tool that allows us to measure
the efficiency of our production and sales process.
I'll show you how that works in a minute
but first let's jump back to indirect costs. These are the costs
of running a business which can't directly be traced back
to the production of goods or the provision of services.
We sometimes call these overheads. Overheads can include fixed costs
like rent employee salaries
insurance costs admin expenses
legal costs accounting costs
marketing costs depreciation and amortisation
there's a lot of them! Fixed costs like these
tend to remain the same they bear no correlation at all
to the sells that your business has made. However not all overheads are fixed.
Variable overheads can loosely correlate with a business's sales
although they can't be directly traced back to the production of goods
or the provision of services. These include things like
advertising costs which can indirectly drive sales
and sales commissions. Utility costs could also be considered
a variable overhead in a manufacturing business
because these can increase as we ramp up production.
When we deduct our indirect costs of doing business from our gross profit
we come to our operating profit. Operating profit measures the
net income that we've generated from operations
this is the residual amount that's left over after deducting
all of our direct and indirect costs of doing business.
So this is our basic income statement but how does it help us measure
a business's financial health? It does that by giving us a means
to compare our financial performance against comparative accounting periods.
A comparative period is a different period of time.
It can be whatever we want it to be we can compare
a current month income statement against last month's income statement
or this year versus last year. When we use comparative periods
we can calculate the change or movement across each line item
down the profit and loss statement and as accountants it's our job
to support these movements with a narrative which explains
all of the differences. Let's throw in some numbers
into an imaginary company and I'll show you what I mean.
We'll compare the movements in our P&L year-on-year.
This is going to be for a medium-sized business
so we can quote our numbers in thousands of dollars.
What have we got here? Our imaginary company
has made sales of a hundred and ten thousand dollars
which is up ten thousand dollars from what we made in the prior year.
Our cost of goods sold have also increased by
ten thousand dollars from $30,000 to $40,000
that's left us with a gross profit of seventy thousand dollars
which has remained unchanged. Our overheads are fixed
at forty five thousand which gives us an operating profit
of twenty five thousand dollars in each period.
What can we learn from all of this? Well our sales have increased
by ten thousand dollars but our gross profit has remained exactly the same.
How can that be? A useful metric that we can use
to analyse this is gross profit margin. We can calculate our gross profit margin
by taking our total product sales and deducting our costs of goods sold
and then dividing the whole lot by our product sales.
This measures how efficiently we've been producing and selling
our imaginary product. In this case our gross profit margin
in the current year is around 64% which is actually down
from last year's gross profit margin of 70%. How is that possible?
Well one of two things could be happening here.
Our sales can be shrinking or our costs could be rising.
We could be selling more products but at a discount
or the cost of our raw materials could be rising.
These are the questions that we need to be asking ourselves
as accountants investors or small business owners.
We can compare metrics like the gross profit margin
across comparative periods to help us identify what questions
we should be asking and then that's when the work begins.
We need to find out the answers and use them to build a narrative
that explains what's going on. Gross profit margin is just one of many
business metrics that we can use to analyse the income statement.
If you'd like to see me make videos on the others let me know.
Now this is still quite a basic income statement.
In reality there are other indirect costs of doing business which we might
need to include as well. Things like interest expenses and tax.
These tend to slot in below operating profit
because they aren't considered to fall within the normal
cost of operations. This is why operating profit
is also known as EBIT or earnings before interest and tax.
When we deduct interest in tax from
our operating profit we calculate our net profit
the bottom line because it's at the bottom
of the profit and loss statement. So you can see that there are many
different types of profit and loss to consider in accounting.
We start off with our revenue and we deduct our direct costs
of doing business to come to our gross profit
our top-line profit. Below this we take out
the indirect costs of running our business to find our
operating profit our EBIT
our earnings before interest and tax and when we remove interest and tax
we calculate our net profit the bottom line.
Together these different types of profit help us measure
performance over a period of time. The main goal of most businesses
is to maximise their profits so it's important to be clear
on what that means and to be aware of the differences
between gross profit operating profit and net profit
which can each tell us a different part of the story.
Like I mentioned earlier the income statement is just one
of the three main financial statements along with the balance sheet
and the cash flow statement. I've made videos covering
both of these already which you can find here and here.
If you found this one useful give it a like
or better yet share it with a friend
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for more accounting tutorials! I'll see you round.