How to read an income statement

As a manager you are not expected to be an accountant. But you need to understand financial statements. Here I will walk you through the profit and loss statement also called the income statement.

Although I am going to make this simple, please note my aim is not, in any way to trivialize the importance of accounting or accounting statements. My main purpose in this article is to make reading such a statement a little less intimidating. So here we go.

The profit and loss statement, also referred to as the income statement basically tells you how much you have made or lost through business activities.

Think about it. This should be quite straightforward. In a nutshell it should be as follows:

–          How much we sold

–          How much it cost us to sell

–          The difference is our profit (or loss)

There it is, as simple as that. Of course I am avoiding getting into any jargon here. If you are interested in that go ahead and grab a book about accounting. You can look up accrual and realization conventions, depreciation rules, matching, allocation and costing conventions, the list goes on.

I am here trying to put everything in perspective and to cut to the chase. If you look at an income statement with the lens that I provided, you will find it easier to read it.

Remember we are assuming that your accountant already put the income statement together. Here we are attempting to read and understand this document not to recreate it.

To understand the “how much we sold” part, you may find some detail such as the number of units sold and the price of each unit. If it is services that you sold, then you will find a total or breakdown of your billings.

Under the “how much it cost us to sell” you may find the cost of units, raw materials, salaries, advertising, rent, distribution, research and development depending on your type of business. Either way it is everything that cost you as a business to run the business and to accomplish your sales.

There is one peculiar item that you need to look out for. Depreciation. This confuses a lot of people because it seems like a one time “cost” but keeps popping up in each income statement. Let me elaborate.

When you buy say, a piece of machinery, to use to make your product, you might have spent a considerable amount of money on it. Let’s say you spent $100,000. The machine may last for five years as you use it to make your widgets. Now let’s say that in your first year you make sales of $150,000 (I am just using random numbers for illustration). Your other costs are $60,000. Then there is the cost of this piece of machinery. If you put in the entire $100,000 then it will look like this:

Sales: 150,000

Machine cost: 100,000

Other costs: 60,000

Profit or loss: 150,000 – (100,000 + 60,000) = -10,000 (i.e. a loss of $10,000)

Really it is not fair to have all the machine cost added in the first year and show a loss. It won’t look good on the statement. It will make your investors and your bank angry.

So the government allows businesses to spread the cost over a number of years. There are all types of depreciation rules and your accountant will be able to handle that. Let’s make it simple here and just say that the machine’s cost will be spread over 5 years equally i.e. 20,000 per year. Now, the numbers look a lot better:

Sales: 150,000

Machine (depreciation) cost: 20,000

Other costs: 60,000

Profit or loss: 150,000 – (20,000 + 60,000) = 70,000 (i.e. a profit of $70,000).

Now that looks really good, doesn’t it? Your banker will be happy and your investors will be too.

There is really nothing more to it. Remember all I am offering here is a “lens” to look at the profit and loss (income) statement. If you understand what I just wrote then you are well on your way to understanding that statement. If you need to dig in deep, get one of those manuals that take you in step by step to cover accounting principles.

Hope you found this useful. Let me know what you think.

 

Thanks for reading.

 

Muneer

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