Your income statement shows the performance of your company over a period of time and reveals important information about how efficiently you are running your business. Understanding your income statement, and what it tells you about the health of your business, is critical.
So in this module we’re going to talk about the financial processes of your business. That encompasses the income statement and the cash flow statement. The income statement and the cash flow statement sit right on top of your balance sheet, on top of the financial foundations of your company. So the balance sheet is a static snapshot of your company’s health at any given point in time. Your income statement and your cash flow statement show your financial processes. And that’s like a video of your business over a period of time. And so while your balance sheet is as of a certain date your income statement is over a period of time.
First, of course, at the top of your income statement are sales or revenues. One thing we get from some first‑time entrepreneurs, they start calling sales the same is income. And that’s not right. Don’t call it income. Income is at the bottom of your statement, not at the top. Now below your revenues are your costs of goods sold. The costs that you incur to make the product that you’re going to sell. It’s the material you use. It’s the labor you put into a building it. Those are the costs of goods sold. So you’ve got your revenues. You’ve got your costs of good sold underneath. You subtract cost of sales from revenues and that gives you your gross profit. Your gross profit is the profit that you make, the difference between the cost and the revenues. Your gross profit margin is the percentage of that profit measured against the sales number. If you make something for $50 and you sell it for $100, your gross profit is $50. Your gross profit margin is 50 percent. So sometimes entrepreneurs make the mistake of saying hey, if I sold it for $100 and I made it for only $50, that $50 profit is 100 percent profit. That’s wrong. The gross profit number is calculated on the sale number, not on the cost number. Get that right. Investors love it when you have a big gross profit margin. So you’ll hear investors ask what’s your margin. Because they want to know, is the fundamental structure of your business really profitable. So we as investors, we like to see companies with a gross profit margin of 70 or 80 percent. We hate it when a company has a gross profit margin of only like 10 or 20 percent. That gives you very little wiggle room to grow your company if your margin is that small.
The next thing on your income statement are your operating expenses. So that includes things like your R/D and your engineering. It includes your marketing and sales. It includes some of your operation and administrative activities. Traditionally accountants will say, okay, you have this expense item which is called S.G.A. S.G.A. means selling, general and administrative expenses. They lump all of these different expenses into that one category. That’s not very useful to you as an entrepreneur. As an entrepreneur you want to be able to take apart the processes of your business into the important components. I want you to manage your income statement the way you run your business, not the way a bookkeeper wants you to run your income statement. Think about what are the critical activities of your business and then organize your income statement, operational expenses according to critical activities of your business. Such as key activity is, building the product. So put the R/D and the engineering together into one expense category. How much do we have to spend each month to build and maintain and support and continue to develop this product. Administration also may be a separate activity. What do you have to pay for the infrastructure of your business? You know, the rent on your building, the cost of your data lines and phones, things like that. So you put together all of those operating expenses, you deduct those from your gross profit and that becomes your operating profit. Your operating profit shows the profitability of your company’s operations.
You know, a lot of what I’ve been saying about the income statement and the details of the income statement sounds like a lot of work, right? So I really encourage you, don’t take it on yourself. There’s all these details of running a business that can overwhelm you as the entrepreneur. I strongly encourage you, get a great office manager who can take care of all of these details, can make sure that your books are in order and can keep you focused on the most important parts of your business.
Well I mentioned before investors are really interested in your margins. Particularly focus on your gross margin, obviously at some point they’re going to be really interested in your operating profit margin. And finally your net margin, which is the net income margin. So they’re going to look at those numbers as indicators of how profitable you are and how efficiently you’re running your business. But there are some other deeper dives that investors are going to do into your income statement. They are going to be looking for what we call operational efficiencies. How efficient are you at running these processes compared to our other companies? So they are going to do ratios on, you know, how much are you spending on marketing compared to your revenues, how much do you spend on sales compared to your revenues, and how do those ratios compare to other companies in your business and other companies in their portfolio. So you’re going to want to learn to look at these ratios. And you’re going to want to focus on figuring outer how to get those ratios in line with the expectations of investors. And even better for your own sake, how can you squeeze more profit out of your company by being even more efficient than you are.
Berman, Karen and Joe Knight. 2008. Financial Intelligence for Entrepreneurs: What You Really Need to Know About the Numbers. Harvard Business Press.
Richard Roth. “Understanding the Income Statement”.
Questions for You
What are the main drivers of my revenues and costs?
What details of revenues and costs should I measure and monitor?
Which is more important for our company right now: growing more quickly, or operating more profitably?
Tools and exercises
Organize your income statement around the main drivers of revenues and costs.
Produce an income statement on a monthly and quarterly basis.