"Life is really simple, but we insist on making it more complicated"
What is the income statement?
When it comes to financial reporting, there's nothing simpler than the income statement, which is also known as a P&L or profit and loss statement. On a basic level the report reflects total revenue and other income along with expenses and losses. The income statement provides a net profit or loss for any given period. Simple. The business world has, of course, found ways to make this much more complicated.
This report now has many different names, including the "statement of activity." Also, the categories of expenses or revenues, especially in large corporations, can seem endless.
Related reading: Taming the Beast That is Financial Reporting
Clear, complete, and accurate bookkeeping is paramount to managing your business growth.
On the other hand, the simplicity of the income statement can lead business owners to overlook some key items. Even worse, it may cause owners to overlook cash flow problems. A keen business owner will be able to keep things simple while knowing how to dig a step deeper to stay squarely focused on the business' most important metrics.
Setting a budget
Numbers without context are just that. You must be able to set a budget for each cost and revenue category so that you have something against which to measure your progress. Setting a budget is key to being able to understand your income statement, as well as manage it.
Related reading: Build a Small Business Budget in Six Easy Steps
Importance of a good bookkeeper
Keeping things clear and simple starts with a good bookkeeper. A good bookkeeper can ensure that the different categories for revenue and expenses are clear, reflect the information correctly, and the information is put into the correct categories.
Accounting systems can be bogged down by multiple accounts with too many miscellaneous categories. A helpful voice can ensure that your costs are consolidated enough, while still enabling you to manage each section effectively. Also, if expenses are wrongly categorized, they may not reflect correctly on the income statement. A common issue with revenues is when gift cards are counted as revenue before they are used or redeemed during a purchase for goods or services. Yes, selling a gift card puts money in your account, but you haven't yet incurred any costs related to selling the product or service. This can lead to getting an incorrect gross profit number.
Related reading: A good bookkeeper is key and will only become more crucial
If the income statement is clear, you can be confident when you dig deeper into the report. You can use it to ask the questions that will help further your understanding of how your business operates.
One key to asking the right questions is to start with the "boulders." These are the big picture, most important and high priority issues. Once you've identified those and understand them, ask more questions to understand the "pebbles." The pebbles are issues that are still important to consider. Lastly, the "grains of sand" are the small issues and details that are the lowest priority.
Some good questions to ask to understand if your revenues and costs are appropriate are as follows:
Digging deeper into income with good questions
Your company's revenues on the income statement are related to the money you make from selling a product, service, or software to your customers. Revenues are recognized based on when you complete a project, delivery a good, or a customer uses a service or software. Revenues are usually not the same as when you receive cash. This is a very important concept to understand. It often helps to speak to a professional so that you are accurately recognizing your revenues, while also deeply understanding how and when you get paid by your customers. Revenue recognition is tied to generally accepted accounting principles (GAAP) standards, whereas cash is tied to the contract that you sign with your customer. You determine the payment terms, which have a big impact on your cash flow.
- Do you understand the difference between revenues and cash, and how it relates uniquely to your business?
- How much are you charging for your product, license, or service?
- What competitive advantages are unique to your business, and how well protected are they?
- What is your total available market (TAM), serviceable addressable market (SAM - % of TAM), and serviceable obtainable market (SOM - % of SAM) – do you understand how and when you’ll reach those customers?
- Can your proposed customers afford your goods or services?
- Who are you selling to, and what are their demographics?
- Where and how are you selling your goods?
- What is your marketing strategy?
- Is your gross profit enough to cover your operating expenses?
- What is the gross margin for each unit sold?
- How many units, licenses, or services are you selling now?
- What are your competitors charging?
- What is industry standard pricing?
- What is your unit sales profitability?
- How and when will your customers pay?
- Do you first need to pay for a product before it can be sold?
"Grains of sand"
- Do you have scalability with where your current pricing is at, so that when you reach a certain threshold, do it then begin to cover operating expenses?
- At what amount is that threshold reached?
- Do you have enough sales people to achieve that?
- Is the amount that you are spending on marketing sufficient to reach certain thresholds for profitability?
- What affect will five, ten or fifteen percent increases ( or decreases) in pricing have?
- What is your three, six and twelve month outlook or forecast for sales?
- What is the lead time on purchased product?
- Does your software need to be built out further to deliver on your contracts – what will that take?
- Will you need to do accounts receivable factoring to cover any cash gaps – what is the interest rate on that – can you afford it?
Cost of goods sold (COGS)
These are costs on your income statement that are directly related to the delivery, production, or servicing of your product, software, or service. These are costs related to inventory, server hosting, production facility expenses, production travel, production or service salaries or contractors, delivery, freight. The list goes on and on. Start with the biggest costs and work your way down from there.
- What services do you have to provide to deliver your product, service, or software?
- What level of customer service is required and what are your competitors doing?
- Have you spoken to industry experts to validate your assumptions about these costs?
- Do these costs change with the number of units sold?
- What people or services do you require now and in the future?
- What equipment do you need to purchase to deliver or produce your goods, services, or software?
- What costs do you need to plan for as you grow?
- Are there grants you can get through the government or vendors to mitigate any of these costs?
- How many people will you need?
- Do you need to outlay funds now so that you have product to manufacture your goods?
- Will you need to buy certain insurance, if so, when?
- Are your people going to be paid as W2 or as 1099 contractors?
- Do you understand the legal ramifications of W2 vs 1099?
- Can you finance the purchase of your production equipment and what is the interest rate?
- How do you get any potential grants and where do you look?
"Grains of sand"
- Do you have any economies of scale as your production increases? If so, for which costs, and at what threshold do you realize those savings?
- Do any of your costs go away over time, which ones and why?
- Do you understand the differences in cost associated with W2 and 1099?
- Will making your people W2 or 1099 give you a competitive advantage?
- How are your competitors paying their people?
- How will you be accounting for the prepayment of expenses?
- What is the lead time on the ordering and payment of production goods?
Operating expenses (OPEX)
These are costs that are related to running your business, that are not classified as cost of goods sold on the income statement. They are things like general office rent, insurance, general wages or professional services (legal, accounting etc.), benefits, corporate and sales team travel, meals and entertainment, marketing, advertising and interest expenses. Operating expenses are usually broken down into separate categories. I prefer to see them listed as General and Administrative (G&A), Sales and Marketing, and Engineering. You can also separate out your payroll so that it is clear what your people costs are.
- Do you need insurance?
- Do you need office space? (Unless you feel that you must have your staff close by so that you can manage them (W2 only!), or that you’ll have customer meetings there you do not need office space – in my opinion)
- How many people are needed to develop your software or product?
- Will your people be W2 or 1099? (again do you know the regulations and laws around each categorization?)
- What people will you need to run your business?
- What systems will you use to run your business operations? (think project management, finance, accounting, etc.)
- Will you need to travel to sell your product, service, or software?
- Do you know how to use the systems, and what they cost?
- What payroll system will you use?
- When do you need to file sales tax (if applicable) and where?
- What types of insurance do you need?
- How much traveling will your do, and what will it cost?
"Grains of sand"
- Can you set up a payment plan for your insurance and what is the finance cost?
- What will you pay each person, and when will they start?
- How often will they get paid?
- When is sales tax paid or due?
- Will you offer benefits?
- When do you make your rent payments?
- Are there any discounts for prepayments on any operating expenses, and most importantly can you afford to outlay that cash all at once?
- Can you save any money on travel by instead doing teleconferences and what do those systems cost?
General income statement questions
- Are there any categories of expenses that make up a large amount of the total cost of goods sold?
- Are there any expenses that seem too high based on the budget you’ve set?
- Is the business spending too much on any area as compared to the budget, and why?
- How will you mitigate growing costs that are outside of your budget, and can the business survive if costs continue to grow?
- How much can costs grow, holding unit revenue constant before there is an issue?
- Does my pricing need to be increased to cover not only the cost of goods sold, but also operating expenses?
Income statement take aways
This list is by no means exhaustive, but is intended to help guide your thought process and stimulate conversation around your business.
In our opinion, ensuring that your records are clear, complete, and accurately represented is paramount to being able to manage your company's continued growth. Without good, clear, bookkeeping and an income statement, it is hard to have the confidence to act and make the best business decisions.