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The income statement

Revenue less the cost of what was sold, less the period's overheads and interest, with loan repayments, drawings and equipment kept off it, and its margins.

Paper packet. Every task here also exists on screen, where it is checked automatically; answers written on paper are not assessed by Nydus. When you are back at a device, enter your answers there.

1. What you will learn

You will build an income statement from a month's figures — gross profit, overheads, operating profit and the interest on borrowing — keep off it the money that left the account for other reasons, and read its last line as the answer to whether the month earned more than it cost. You will also work its gross and operating margins to compare months of different sizes.

2. What you already have

You have read a simple profit and loss, and spent the last unit separating profit from cash. The income statement is the formal version of the profit side: the statement built to answer one question about a period. Everything on it is addition and subtraction, and the new skill is sorting — deciding, for each thing that happened in the month, whether it belongs on the statement at all, and on which line. Two ratios at the end turn the statement into figures that can be compared from one month, or one business, to the next.

3. Words this lesson uses

4. One question, three lines

The income statement answers did this period earn more than it cost? — and nothing else. It is built in three steps, top to bottom.

$$\text{gross profit} = \text{revenue} - \text{cost of goods sold}$$

$$\text{operating profit} = \text{gross profit} - \text{overheads}$$

Gross profit says whether the price covers what went into the thing sold. Operating profit says whether what is left covers the cost of being open. Where the business borrows, the interest is then taken off, because it is the price of the money the business used this month.

What stays off it is the other half of the skill. Repaying a loan returns money that was borrowed; it is not a cost of this month's sales. The owner's drawings hand profit to its owner; they are what the profit is for, not a cost of making it. Equipment bought for years of use is not a cost of the month it was bought in. Each of those left the account, and that is exactly why this statement is not a list of what the account did.

5. The method, step by step, and how to check it

List everything that happened in the period. Sales, purchases, bills, payments, transfers — the whole bank statement and the unpaid invoices too.

Sort each item. Is it a sale of the period? Revenue, whether or not it has been paid. Is it what went into the things sold? Cost of goods sold. Is it a running cost of the period? Overhead. Is it interest on borrowing? Interest. Is it none of these — a repayment, drawings, equipment, the owner putting money in? Off the statement.

Add and subtract down the page. Gross profit, overheads, operating profit, interest, profit.

Work the margins. Gross profit and operating profit, each divided by revenue and multiplied by a hundred.

Check the statement two ways. First, every item on the list should be either on a line or deliberately left off, with nothing forgotten. Second, the margins should make sense against each other: the operating margin is always below the gross margin, and the gap between them is the overheads as a share of revenue. A statement where the operating margin is higher than the gross margin has an overhead entered with the wrong sign.

6. Interest and repayment: one payment, two lines

A monthly loan payment is usually a fixed amount, and it hides two different things. Part of it is interest — what the lender charges for the money the business has had the use of this month. That is a cost of running the business, and it belongs on the income statement. The rest is repayment — money the business borrowed coming back to the lender. That reduces the debt; it is not a cost of anything this month.

Early in a loan most of each payment is interest; later, most is repayment. The lender's statement shows the split. Taking the whole payment off profit makes every month look worse than it was, and makes the profit look as if it rises as the loan is paid down, when it is only the interest that is falling.

7. Margins: comparing months that are not the same size

An operating profit of 1,800 in a 12,000 month and 1,400 in an 8,000 month are hard to compare as they stand. As margins they are 15 percent and 17.5 percent, and the smaller month turns out to be the more efficient one.

Gross margin moves with prices and with what the goods cost: a supplier's price rise, a discount, a change in what customers buy. Operating margin moves with all of that and with the overheads: a new member of staff, a rent review, a quiet month in which the same rent is spread over less revenue.

So when profit changes, the two margins together say where to look. Gross margin steady and operating margin down: the overheads have grown, or revenue has fallen against fixed costs. Gross margin down: look at prices and at what the goods cost before anything else.

8. Which month a sale and a cost belong to

The income statement puts each sale and each cost in the period it belongs to, which is not always the period the money moved. Accountants call this the accruals basis, and it is what makes the statement answer its question.

A sale belongs to the month the work was done or the goods handed over. The catering job delivered on 28 March is March revenue, even if Harbor Office pays in April. A deposit taken in March for a wedding in June is not March revenue: it is money held for work not yet done, and it becomes revenue in June.

A cost belongs to the month it helped earn revenue. March's electricity is a March cost, though the bill arrives in April. A year's insurance paid in January is a twelfth of a cost in each month, not all of it in January. Stock bought in March and sold in April is an April cost of goods sold.

This is why the income statement and the bank account disagree, and why both are right. The account records the day the money moved; the statement records the month the earning happened. A very small business may keep its records on a cash basis — counting money when it moves — where the rules allow it, and many do for simplicity. But the question did March earn more than it cost? is only answered properly when March's sales and March's costs are set against each other, wherever the money happened to land.

9. In the world: a café owner's first income statement

A café owner in her first year has been judging months by her bank balance. Her accountant sends her first proper income statement, for the quarter: revenue 36,000, cost of goods sold 12,600, wages 10,800, rent 4,500, other overheads 2,700, and interest of 180 on the fit-out loan. Over the same quarter she repaid 1,020 of the loan and took 4,500 in drawings, and bought a second grinder for 1,200.

Gross profit is 36,000 − 12,600 = 23,400, a gross margin of 65 percent. Overheads total 18,000, so operating profit is 5,400, an operating margin of 15 percent. After interest, profit is 5,220.

Her bank account tells a different story: it fell over the quarter, because the repayment, the drawings and the grinder together took 6,720 out — more than the 5,220 the café earned. Nothing is wrong with the café; she was taking out, paying back and investing faster than it was earning.

The margins give her something to watch. Her supplier's price list says a cup costs about 35 cents in every dollar, which matches the gross margin. Wages are 30 percent of revenue, the largest overhead. She decides to keep her drawings at 1,200 a month until the loan is repaid, and to check the gross margin each month against the 65 percent she now knows is normal.

10. In the world: how investors read margins

Analysts comparing companies of very different sizes use gross and operating margins rather than profits, and compare them with others in the same trade: supermarkets typically run on thin operating margins and high volume, software companies on high gross margins. A small business can use its trade association's published averages the same way, as a rough check on whether its prices and overheads are in line.

11. Where this goes wrong

It lists what went through the bank. It lists what the period earned and what earning it cost, which is a different list: an invoice unpaid at the month end is revenue, and a loan repayment is not a cost.

High revenue means a good month. Revenue is the top line. The question is answered at the bottom.

Drawings are the owner's wage, so they are an overhead. In this course drawings are money taken out of profit, and they stay off the statement. Where an owner is paid as an employee, the legal and accounting form of the business decides it, and that depends on where it trades.

The whole loan payment is a cost. Only the interest is.

Gross margin and markup are the same number. Margin divides by revenue; markup divides by cost.

A deposit is revenue when it arrives. It is money held for work not yet done, and becomes revenue in the month the work is delivered. Until then it is something the business owes the customer, in work or in money.

Every payment belongs on the income statement. Loan repayments, drawings and equipment bought are payments, not costs of the month, and each has its own place.

12. Fixit Mobile's quiet February

1. Find the gross profit: revenue 7,000, parts sold 3,150.

   $7000 - 3150 = 3850$

   The price covers the parts with room to spare.

2. Find the gross margin.

   $3850 \div 7000 \times 100 = 55$

   Fifty-five cents of every dollar after the parts.

3. Add the overheads: wages 2,000, rent 1,100, insurance and van 900.

   $2000 + 1100 + 900 = 4000$

   The cost of being open, whatever was sold.

4. Find the operating profit.

   $3850 - 4000 = -150$

   A loss of 150.

5. Read the two lines together.

   $\text{healthy margin, too little sold}$

   The price was right; the month did not sell enough to cover the overheads.

13. Corner Bean's March, sorted from the bank statement

1. Find the gross profit: takings 12,000, beans, milk and cups 4,200.

   $12000 - 4200 = 7800$

   Revenue less cost of goods sold.

2. Add the overheads: wages 3,600, rent 1,500, power and fees 900.

   $3600 + 1500 + 900 = 6000$

   The month's running costs.

3. Find the operating profit.

   $7800 - 6000 = 1800$

   What trading earned.

4. Split the loan payment of 400: 60 interest, 340 repaid.

   $1800 - 60 = 1740$

   Only the interest is a cost.

5. Leave off the 340 repaid and Alexa's 1,500 of drawings.

   $1740 - 340 - 1500 = -100 \text{ is what the account did}$

   The account fell by 100; the month earned 1,740.

6. Work the operating margin.

   $1800 \div 12000 \times 100 = 15$

   Fifteen cents of every dollar left after every cost of trading.

14. Two months compared by their margins

1. Find March's gross margin: revenue 12,000, gross profit 7,800.

   $7800 \div 12000 \times 100 = 65$

   The first month.

2. Find August's gross margin: revenue 9,500, gross profit 5,700.

   $5700 \div 9500 \times 100 = 60$

   Five points lower.

3. Find March's operating margin: operating profit 1,800.

   $1800 \div 12000 \times 100 = 15$

   After the overheads.

4. Find August's operating profit: overheads 5,900.

   $5700 - 5900 = -200$

   A small loss.

5. Find August's operating margin.

   $-200 \div 9500 \times 100 \approx -2.1$

   Below zero.

6. Split the fall into its two causes.

   $\text{gross margin } -5 \text{ points}; \quad \text{same overheads on less revenue}$

   Both the goods and the quiet month played a part.

7. Name where to look first.

   $\text{the milk price and what customers bought}$

   A five-point fall in gross margin is worth 475 on 9,500 of revenue: more than the loss.

15. Your turn: revenue 9000, cost of goods sold 3600, overheads 4800

1. Find the gross profit.

   $9000 - 3600 = 5400$

   A gross margin of 60 percent.

2. Find the operating profit.

   $5400 - 4800 = 600$

   Gross profit less overheads.

3. Your turn: work this step out. Its working is at the end of the packet.

   Find the operating margin.

16. Guided practice

The figures for Fixit Mobile in November, in dollars. Complete the income statement. Write an operating profit below zero with a minus sign.

17. Guided practice

Complete the worked solution: a month's revenue was $12000$ dollars and its cost of goods sold $5160$. Wages were $1400$, rent $1400$ and other overheads $700$. Build the income statement and find the gross margin.

1. Find the gross profit.

   $12000 - 5160 =$ _p

   Revenue less the cost of what was sold.

2. Add the overheads.

   $1400 + 1400 + 700 =$ _o

   The month's running costs.

3. Find the operating profit.

   $(\text{gross profit}) - (\text{overheads}) =$ _q

   The bottom line answers the question.

4. Find the gross margin.

   $(\text{gross profit}) \div 12000 \times 100 =$ _m

   Cents left from each sales dollar after the goods are paid for.

5. Check what stays off.

   $\text{no loan repayment, drawings or equipment}$

   None of them is a cost of earning the month's revenue.

18. Guided practice

In November, Fixit Mobile had revenue of $10000$ dollars and its cost of goods sold was $4500$ dollars. What was its gross margin, as a percentage?

Answer:

19. Practice

Six things that happened at Corner Bean in March. Sort each into its place on the income statement, or off it.

20. Practice

The owner of Fixit Mobile has listed every figure for November, in dollars: revenue $10000$; cost of goods sold $4500$; wages $2200$; rent $1100$; insurance and the van $600$; loan repayment $350$; owner's drawings $1500$. What was the operating profit? Write a loss with a minus sign.

Answer:

21. Practice

A physiotherapy practice made an operating profit of $2300$ dollars in April. That month it also paid $800$ dollars on its equipment loan, of which the bank's statement shows $59$ dollars was interest. What is the practice's profit for April after the cost of borrowing?

Answer:

22. Somewhere new

A mobile dog groomer's list for May, in dollars: grooming fees $3400$; shampoo, conditioner and blades used $700$; fuel for the van $70$; repayment of the van loan $1100$; money paid to herself $1300$; a new hydraulic grooming table $800$. Fill in her income statement, and the total of the lines that stay off it.

23. Lesson test

Lesson test: one question per skill, one attempt each, no hints. Your answers are checked when you submit.

24. Test question

A bakery's income statement for a month shows revenue of $9000$ dollars, cost of goods sold of $3240$ and overheads of $3690$. What is its operating margin, as a percentage of revenue?

Answer:

25. What you can do now

You can build an income statement, split a loan payment into interest and repayment, and work its gross and operating margins. Tell someone why a loan repayment leaves the account and still stays off this statement. Next: the balance sheet, which answers a question about one day rather than a month.

Working for the steps left to you

15. Your turn: revenue 9000, cost of goods sold 3600, overheads 4800, step 3