The Income Statement
Welcome back to the basics of bookkeeping! Yesterday, we talked about reconciling your bank statements and how to troubleshoot when things go wrong.
Now that you understand how to get the information into your books, it’s important to be able to get it out again. Reading financial statements is an important job for a small business owner and will help you make data-driven operating decisions.
An income statement is a listing of all the revenues a company has generated over a given period of time and all the expenses required to generate that revenue. At the end of each fiscal year, the net income (revenue minus expenses) for the year is added to Retained Earnings on the balance sheet (we’ll go into retained earnings in more detail in a few days), and all the revenue and expenses are reset to zero. This makes the income statement a periodic statement.
Using Your Income Statement
It’s a good idea to look at your income statement monthly (which means your bookkeeping needs to be done at least monthly) to understand where you’re spending money. It’s easy to spend more than you think in places you don’t realize, like your phone, for example. What if you accidentally go way over your data one month and your bill doubles, but you’re set up for auto-billing, so you don’t notice.
Or maybe you like to go to the local sandwich shop for lunch. It’s only $12 for a sandwich and a drink, which you think is totally worth it because it’s so good and you don’t have to make lunch for yourself. But is it? Assuming you work six days a week (because let’s be real, you rarely only work five days), that’s $72/week. By the end of the month, you’ve spent $288 just on sandwiches.
Your income statement also shows you the relationship between revenue and expenses. Some expenses should be the same (for the most part) regardless of the amount of revenue you generate, like internet. It should cost the same amount for internet if you have 1 customer that month or 100. Now I don’t know about you, but if my internet expense suddenly doubled, I would really want to know why that happened, preferably before I get charged that amount more than once.
By looking at your income statement monthly, you’ll be able to see all your expenses in one place and investigate any oddities.
Some expenses are expected to increase as a direct result of an increase in revenue. Credit card processing fees are a good example because they’re a percentage of sales (e.g., 2.9% + 30¢ per transaction). Subcontractors are another example of a cost that usually directly relates to revenue. As you have more sales, you need your contractors to put in more hours, which increases your expenses.
This type of expense should be relatively the same as a percentage of revenue, though. Divide your transaction fees by your revenue: Is it about 3%? If it’s significantly higher, I would try to find out why.
Are your subcontractors always about 40% of revenue? Did that number suddenly jump to 60%? Why? What happened to cause the jump? Maybe one of your customers required an extra 25 hours of contractor work this month, but you can’t bill them until next month. In that case, it might be okay because you know you’ll recover the cost, and the number will come back down next month. Maybe that’s not the case, and one of your subcontractors had an error in their invoice. You’d want to catch that sooner rather than later.
If you’re checking your income statement monthly, you’ll begin to develop an expectation for what it should look like. If your numbers don’t meet your expectations, you can ask yourself why that happened. Doing so will always lead to information you wouldn’t have otherwise had.
Task: Create the same income statement you did on Day 3. Use the ratios described in this lesson to get even more information from the same report. Your income statement will help you run your business, but only if you understand the underlying relationships between income and expenses.
Join me tomorrow for an overview of the balance sheet and a detailed review of assets, which are what your company owns.
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