One of the most important things for a business to understand is its profitability—literally, its ability to make a profit from the products it creates or sells. There are two key factors in determining profitability: (1) how much revenue the sales of the products generate; and (2) how much it costs to make and deliver those products. The simplest way to think about the income statement is with the simple equation below:
Total Revenues – Total Expenses = Profit(or Loss)
In essence, subtract the amount everything cost the business from the amount of revenue (or income) the business earned to see the profit. If things cost the business more than it earned in revenue, the company will see a loss.
Of course, it’s not really that simple. There are different ways a business can make money, such as selling equipment. And there are also many expenses a business might incur during that same period of time. The income statement goes one step further, adding more detail so that people can understand where the key sources of income and expenses are.
To help us better understand this statement, let’s look at an example from SunsTruck. Note that when a number is negative, it appears in parentheses.
At the top of the statement, you’ll see that it clearly identifies three things: (1) the name of the company, (2) the title of the financial statement, and (3) the period of time the statement is summarizing. For this example, we’re looking at the income statement for SunsTruck for the Third Quarter (“Q3”), or the three months ending September 30, 2016.
The first category of numbers at the top is called revenues. This is the total amount of income that the company earned during this time period. You can see that there are two main sources of revenue, or income for SunsTruck: (1) sales revenue, which is the money the business earned from selling its main product, sunglasses; and (2) other revenue, which is the money the business made from other sources, such as selling old equipment. For this quarter, SunsTruck made $80,000, which is shown as total revenues.
The second area of revenue is related to the cost of earning that revenue. If you are in the service industry like a hospital or software design, this is called cost of revenues. In our example, SunsTruck sells a physical product, sunglasses, so it is called cost of goods sold (COGS). This number represents the direct cost of either making the products or purchasing them from the supplier. In the case of SunsTruck, this number is the amount of money the company spent to buy the sunglasses from brands like Oakley or RayBan that were then sold in their truck. In the third quarter, SunsTruck spent $40,000 on sunglasses to sell in their truck.
The third area of revenue shows gross profit-—total revenue minus the cost of goods sold. The amount of gross profit that SunsTruck earned this quarter is $40,000. It is the total revenue minus the total COGS ($80,000 revenue – $40,000 COGS = $40,000 gross profit). Gross profit is a very important number to know, because it is what’s left over to cover all of the business’s other expenses. If gross profit is not high enough, the company is losing money and (eventually) will go out of business. In our SunsTruck example, the business has $40,000 in gross profit to cover its remaining expenses.
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