Beyond the Numbers: How to Interpret and Use Your Income Statement

The income statement is one of the three essential financial statements that business owners and investors use to analyze a company's profitability and growth potential. Understanding the income statement and the story behind the numbers will provide you with valuable insights for your business and investments, enabling you to identify areas for growth and improvement.

In its basic form, the income statement has three key components: 1. Revenue, 2. Expenses, and 3. Net Income. Put another way: Revenue - Expenses = Net Income.

1. Revenue shows how much the business is generating and from what sources. Publicly traded companies must follow strict guidelines for compiling their financial statements and itemizing their revenue. However, a good rule of thumb for small businesses is to itemize any segment of your business that generates 10% or more of your overall revenue. This approach allows you to analyze your operating segments in a meaningful way without your income statement becoming too convoluted.

   
   

2. Expenses are the costs incurred in generating revenue. There are three main types of expenses on a basic income statement: cost of goods sold (COGS), operating expenses, and non-operating expenses. Analyzing your income statement involves breaking down your revenue into ratios or percentages that provide insights into your business and help you tell its story. Let me explain how.

• The first type of expense is COGS. These are the direct costs associated with producing your product or delivering your service. The key word here is "direct"—these costs can be easily traced back to your product or service. For example, if you sell cars, COGS would include labor, materials like nuts and bolts, the car body, and the interior. When you subtract COGS from your revenue, you get your gross profit. Gross profit reflects your profitability based on your core business model. By dividing gross profit by revenue (Formula: Gross Profit / Revenue), you calculate your gross profit margin. This percentage is useful for analyzing industry comparisons and year-over-year (YOY) metrics. A healthy gross profit margin typically ranges between 30% and 50%, depending on your industry and business size.

• Next are operating expenses (OPEX), which include the costs of running your day-to-day business. Operating expenses include rent, utilities, insurance, selling, general and administrative (SG&A), and research and development (R&D) costs. While essential for running your business, these costs cannot be directly traced back to the production of your goods and services. Subtracting operating expenses from gross profit gives you your operating income, which reflects your business's operational efficiency. You can also calculate your operating margin by dividing operating income by revenue (Formula: Operating Income / Revenue). A good rule of thumb for a business owner is to maintain an operating margin between 10 or higher. Of course, this percentage is highly dependent on the business you are operating within.

• The final type of expenses are non-operating expenses. These are costs that are not directly related to your company's primary operations. Non-operating expenses might include interest expenses, most taxes (such as income taxes), inventory write-offs, legal fees, and currency fluctuations for multinational companies. When you subtract non-operating expenses from operating income, you will arrive pre-tax income. From there, subtract your taxes to arrive at net income. Taxes are a non-operating expense but are itemized on the income statement.

3. Net income represents the overall profit generated by the business. You can calculate your net profit margin by dividing net income by revenue (Formula: Net Income / Revenue). A 10% net profit margin is generally considered average, while a 20% margin is considered excellent. Here's why: The S&P 500 has averaged a 10.26% return since its inception in 1957 through the end of 2023, according to Investopedia. As a business owner, you're investing significant time and effort into building and running your business, which presents a trade-off: investing in the market or investing in your business. While the S&P 500 can serve as a useful benchmark, I do recommend exercising caution and not loosing sight of the bigger picture.  A 10% profit margin positions your business well for long-term growth and profitability. When analyzing your financial performance, I also recommend to focus on industry-specific benchmarks and year-over-year comparisons, as well as evaluating your performance against previously developed financial forecasts.

So there you have it! A basic income statement. To summarize:

• Revenue - COGS = Gross Profit

• Gross Profit - Operating Expenses = Operating Income

• Operating Income - Non-Operating Expenses = Pre-Tax Income

• Pre-Tax Income - Taxes = Net Income

At J’s Limited, we are committed to making financial education accessible to everyone. If you're seeking practical solutions for your personal or business financial needs, don't hesitate to reach out to me at jslimitedgroup@outlook.com. I'd be happy to chat!