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Understanding Your Financial Statements – The Income Statement

Understanding Your Financial Statements – The Income Statement

When referring to your financial statements, accountants often get asked questions such as:

  • Did we make money this year?
  • What does my P&L tell me?
  • How is the business doing?
  • Why isn’t my cash equal to my profit?

The income statement (also known as the profit and loss statement) details the company revenue and expenses with the bottom line being the profit or net income of the company. This statement is prepared according to accounting rules. These rules require that revenues be recognized when the sale takes place, which may not be when cash is actually received. The accounting rules also require that expenses be recognized when they are incurred, which may not be when cash is actually paid. This method is called accrual accounting and is distinct from a cash based system. As such, the cash a corporation has at the end of the day may be very different then the profitability noted on its statement of income.

Basic categories on the income statement would include revenues, cost of goods sold, operating expenses and non-operating revenues and expenses. The revenues section include all sales completed during the period and may not include cash collected in advance of providing the related product or service. For example, if $1,100,000 in cash was collected for product sales, however only $1,000,000 in product was assembled and delivered – revenues would only total $1,000,000.

The cost of goods sold (or cost of service) section would include costs directly attributable to earning the revenues, such as inventory, materials or direct labour. The amounts included in this section would only relate to the sales that have been recorded for the period. For example, if $385,000 in product (at cost) was ordered and only $350,000 in product was delivered – only $350,000 would be recorded here. Revenues less the cost of goods sold result in gross profits.

The gross profit line is a good determinant of the profitability of the company. Taking the gross profit divided by sales will provide the percentage of profitability for each sale and is a good indicator for setting sales targets to meet overall break even and profit targets. For example, if the company anticipates a 65% gross profit and its operating expenses are anticipated to be $300,000 – the breakeven point would be sales of $461,538 ($300,000 / 65%).

The gross profit section is followed by the operating expenses. Operating expenses are the cost of operating the business. These expenses are not directly related to sales – such as admin staff, rent, utilities, marketing, office supplies etc.

Revenues – Cost of Goods Sold – Operating Expenses = Net Income from Operations. This formula is an indicator of the profitability of the company solely from its operations. Below this line would include revenues and expenses items that are not part of the company’s overall business, such as interest earned on large deposits or dividends earned from marketable securities held by the company. This is added to arrive at net income before tax. Tax is then calculated as a separate measure (on taxable income, which falls within the rules of the tax act) to then arrive at net income (or net profit).

Timing differences are an important aspect to understanding the company’s statement of income. Revenues are recorded when the customer makes a purchase. However, cash inflow occurs when the payment is received. Revenues therefore may be higher than the cash that was received in one year (where a customer did not pay right away), and revenues may be lower in the following year in comparison to cash receipts (where customers paid amounts owing from the year before while sales for the year decreased).

This is similar in relation to expenses. Expenses are recorded when the expense is incurred. However, cash outflow occurs when the bill is paid. Expenses may be lower than the cash that was paid out in instances where bills were paid in advance such as insurance or retainers for lawyers. Expenses may also be higher than cash paid out when bills are paid late.

While the statement of income is a good indicator of overall profitability of a company and will show if the company made money during the year – it cannot be relied on its own to answer how the business is doing or answer why the cash in the account does not equal the profit. The balance sheet and statement of cash flow will complete the picture and also underline where the cash is coming from and going to, along with providing a big picture of the overall health of the company.

Revenues$1,000,000
Cost of Goods Sold$ 350,000
Gross Profit$ 650,000 (65%)
Operating Expenses$ 300,000
Net Income from Operations$ 350,000
Investment Income$ 50,000
Net Income Before Tax$ 400,000
Income Tax$ 58,000
Net Income$ 342,000

This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action.

Nizam Shajani

I enjoy formulating plans that help my clients meet their objectives. It's this sense of pride in service that facilitates client success which forms the culture of Shajani LLP.

Shajani Professional Accountants has offices in Calgary, Edmonton and Red Deer, Alberta. We’re here to support you in all of your personal and business tax and other accounting needs.