Unit 3 · Topic 3.6 · about 30 minutes
The Income Statement
Build an income statement from a business's numbers, then use its margins to say what is going well and what is not.
Predict first
A neighborhood coffee shop sold $312,000 worth of drinks and food last year. Roughly what share of that did the owners keep as profit after every bill and tax was paid?
What an income statement is
An income statement, also called a statement of profit and loss, compares a business's total revenue with its total costs over a period of time, such as a month, a quarter or a year. The difference is the business's net profit or loss.
It sorts the money into three major categories: revenue, cost of goods sold (COGS) and operating expenses. It also shows interest and taxes, and it identifies any nonrecurring expenses, one-time costs the business does not expect to repeat. It is read from the top down. Each line subtracts one kind of cost, and each subtotal tells you something different about the business. Most income statements show several periods side by side so you can compare this year with last year.
| Line | How it is found | What it tells you |
|---|---|---|
| Revenue | Income from the business's core activities, such as sales | How much the business brought in |
| Cost of goods sold (COGS) | Direct costs of producing what was sold | What the products themselves cost |
| Gross profit | Revenue minus COGS | Profit after direct costs only |
| Operating expenses | Indirect costs: selling, general and administrative, research and development | The cost of running the business |
| Operating profit | Gross profit minus operating expenses | Profit before interest and taxes |
| Interest expense | The cost of borrowed money | What the business's debt costs |
| Pretax income | Operating profit minus interest expense | Profit before taxes |
| Taxes | Owed only when pretax income is positive | What goes to the government |
| Net profit | Pretax income minus taxes | The bottom line: what the owners earned |
Sort it
A bakery has these costs. Tap each one, then tap where it belongs on the income statement.
Cost of goods sold
Operating expenses
Interest expense
Worked exampleBuilding the coffee shop's statement
Northside Coffee had revenue of $312,000 last year. Its COGS were $109,200. Operating expenses were rent $54,000, salaries $96,000, marketing $9,500 and other expenses $14,300. Interest expense was $4,200, and its tax rate is 21% of pretax income. Find each subtotal and the net profit.
Gross profit = revenue minus COGS = 312,000 minus 109,200 = $202,800.
Operating expenses total 54,000 + 96,000 + 9,500 + 14,300 = $173,800. Operating profit = 202,800 minus 173,800 = $29,000.
Pretax income = operating profit minus interest expense = 29,000 minus 4,200 = $24,800.
Taxes = 21% of 24,800 = $5,208. Net profit = 24,800 minus 5,208 = $19,592.
Net profit is $19,592, which is about 6.3% of revenue. That matches the prediction at the top of this lesson.
Margins: comparing profit to revenue
Owners and managers read a business's income statements, and so do lenders and investors on the outside. They watch revenue and costs for trends, judge how profitable the business is, and use what they find to decide how to make it more profitable.
A profit in dollars is hard to judge on its own. $19,592 is a strong year for a coffee cart and a terrible one for a chain. Margins fix that by dividing each kind of profit by total revenue.
- Gross profit margin = gross profit divided by total revenue. It shows how well the business sets prices and manages its direct costs. Northside: 202,800 divided by 312,000 is 65.0%.
- Operating profit margin = operating profit divided by total revenue. It shows how well the business markets and sells, runs its operations and controls operating expenses. Northside: 29,000 divided by 312,000 is about 9.3%.
- Net profit margin = net profit divided by total revenue. It shows overall profitability, the share of revenue that reaches the owners. Northside: about 6.3%.
A margin means most when it is compared with something: the business's own projections, its past performance, or its competitors. To measure how far a number moved, businesses use percent change: (current value minus initial value), divided by the initial value, times 100. If Northside earned $16,000 the year before last, its net profit grew by (19,592 minus 16,000) divided by 16,000, times 100, which is about 22.5%.
Planning ahead: projected income statements and budgets
Everything so far looks backward. An income statement is built from the business's actual records of revenue, expenses and taxes for a period that has already ended. Planning looks forward, and it has to, because income and expenses do not hold still. Customers' needs and wants change, competitors cut prices, and PESTEL forces such as a new tax or a jump in interest rates move both sales and costs. Planning cannot remove that uncertainty, but it helps a business or a household meet its financial goals anyway.
A business plans with a projected income statement, a budget, or both. Each covers a future period, such as a month, a quarter or a year. It lays out the revenue the business predicts, an estimate of every expense involved in running it, and the profit or loss that would result, given how much it expects to produce and sell. Every line is an estimate, and each kind of estimate has its own source:
- Revenue comes from the prices the business plans to charge and from market research about customer demand and industry trends.
- COGS and operating expenses come from planned production processes, the cost of supply chain components, and other expected costs such as rent and other occupancy costs, marketing, office and sales salaries, and planned research and development.
- Taxes are estimated from the projected pretax income.
The projection lets the business plan for the costs it expects, see early whether it will need funding, and keep enough cash on hand to pay its bills as they come due. When the period ends, the projection becomes one of the benchmarks the actual margins are measured against.
Worked exampleNorthside's projected statement for the coming year
Northside Coffee is planning for the coming year. The owner plans a price increase, and market research in the neighborhood suggests customers will keep buying at about the same rate, so she projects revenue of $336,000. Supplier quotes put beans, milk and cups at 35% of revenue, the same share as last year. A new lease raises rent to $57,000, and she plans salaries of $99,000, marketing of $12,000 and other expenses of $14,300. Interest expense falls to $3,600 as the loan is paid down, and the tax rate is still 21%. Build the projected income statement and compare its net profit margin with last year's 6.3%.
Projected revenue is $336,000, set by the planned prices and the market research on demand.
Projected COGS = 35% of 336,000 = $117,600. Gross profit = 336,000 minus 117,600 = $218,400.
Operating expenses total 57,000 + 99,000 + 12,000 + 14,300 = $182,300. Operating profit = 218,400 minus 182,300 = $36,100.
Pretax income = 36,100 minus 3,600 = $32,500. Estimated taxes = 21% of 32,500 = $6,825. Projected net profit = 32,500 minus 6,825 = $25,675.
The projected net profit margin is 25,675 divided by 336,000, about 7.6%, up from 6.3% last year. That is a plan, not a result. A year from now Northside can set its actual statement beside this one and see which estimates missed.
Budgets at home
Households plan ahead too. A consumer budget covers a period, usually a month or a year. It starts from expected net pay, the income left after taxes and other deductions, and plans every use of it: savings, everyday expenses and debt payments. Jada takes home $2,400 a month, and her budget plans all of it.
| Planned use | Amount |
|---|---|
| Rent | $800 |
| Car loan payment | $210 |
| Groceries | $300 |
| Phone | $60 |
| Gas and car insurance | $190 |
| Savings for college | $360 |
| Donation to an animal shelter | $40 |
| Everything else: clothes, eating out, fun | $440 |
| Total planned | $2,400 |
The budget earns its keep at the end of the month, when Jada compares it with what she actually spent. That shows her spending patterns, and whether she is meeting the goals the budget was built around: paying down the car loan, saving for college, and giving to a cause she supports. Topic 5.1 builds a budget from a real paycheck.
Check your understanding
A furniture store had revenue of $850,000, COGS of $510,000 and operating expenses of $255,000. What is its gross profit margin, as a percent?
A restaurant's gross profit margin stayed at 62% from last year to this year, but its operating profit margin fell from 11% to 6%. Which explanation fits these numbers best?
Which item is subtracted from operating profit to find pretax income?
A bike shop's net profit was $42,000 last year and $48,300 this year. What is the percent change in net profit, as a percent?
Two companies in the same industry each earned a net profit of $2 million last year. Company X had revenue of $10 million and Company Y had revenue of $40 million. What does this tell you?
A food truck owner is preparing a projected income statement for next year. Which information should she use to estimate next year's revenue?
Leo's job pays $3,000 a month before taxes. After taxes and other deductions, $2,400 reaches his bank account. His monthly budget plans $1,500 for expenses, $300 for a car loan payment and $100 for donations, and puts the rest into savings. How much does he plan to save each month, in dollars?
A bakery's projected income statements for the next six months show losses in January and February, when sales are slow, and profits from March on. How can the owner use these projections?
Course alignment, for teachers
AP Business with Personal Finance topic 3.6, Unit 3: Personal Saving and Borrowing / Business Finance and Accounting.