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Updated on Dec 19, 2023. Originally published on Jan 24, 2017.
Our very first consulting client was a home healthcare business. As part of our initial analysis, we asked to see financial statements, so the owner handed us a three-ring binder containing monthly financials, meaning an income statement, balance sheet and cash-flow projections.
Related: Here’s What Investors Are Actually Looking For
Each three-page statement was neatly stapled in the upper left corner and three-hole punched, with no crease by the staple — and no indication that the owner had even looked at the second page.
Immediately, we knew that the client did not use those financials to help her run her business.
She was not unique. We often find that small businesses owners don’t fully understand how to read their financial statements. Our six tips will help owners understand what a profit and loss statement (also know as a P&L or an income statement) is trying to tell you, and how to use it to make management decisions. Obviously, there is more to income statements than we can cover here. However, these hints will be helpful as you glean what your income statement is telling you about the health of your business.
1. Income statements cover a period of time
The income statement reveals how much money your business made over a period of time. Most often, the statement reflects performance over a month, a quarter or a year. You’ll also see year-to-date income statements that reflect activity from January 1 through the current date (usually the end of a month).
For example, you might see “Y-T-D August,” indicating the period for January 1 to August 31. The important point is that income statements always cover a period of time and it is important to note that time frame.
2. Every income statement follows a simple formula
Every income statement, no matter how complex, follows a very simple formula: Revenue – Expenses = Profit
It really is that simple. For whatever period the income statement covers, it shows the revenue the business earned, the expenses it incurred and the profit it made.
3. Multiple names for one item cause complexity
One thing that can make income statements seem more complex is that people use different names to refer to the same thing. For example, the term “sales” or “income” might be used instead of revenue. “Expenses” and “costs” are also used interchangeably. “Profit” is sometimes called “net income.”
Just don’t let the jargon throw you. Remember, no matter what terms you use, the money that comes in minus the money you paid out equals the money you get to keep.
Related: How to Make a Balance Sheet
4. Expenses are often split into multiple parts
Another thing that can make an income statement seem more complex is that expenses are usually broken down into components, and profit is calculated at interim levels. For example, you will often see:
- Revenue
- Cost of goods sold
- Gross margin
- Selling, general and administrative
- Profit
In this case, expenses have been broken down into two parts: cost of goods sold (COGS) and selling, general and administrative (SG&A).
COGS are those costs related directly to the products or services that you sold. For example, the material you bought to make the widget you sold and the compensation you paid to the widget-builder would be included in COGS. COGS generally vary directly with revenue, which is a function of the number of widgets sold.
SG&A are those costs which, while necessary, are not related directly to the number of widgets sold. For example, the salaries of the president, the CFO and the salespeople are typically included in SG&A, as are the rent and the utility bills for the office building. These costs are typically more constant month-to-month and don’t vary with the number of widgets sold.
5. Gross margin percent should be relatively constant
With expenses split into two parts, profit is calculated at an interim level called the gross margin. Gross margin is equal to revenue minus COGS. The gross margin (also called gross profit), is the money you receive from the products (or services) you sell, less what it costs you to deliver them. It is very useful to calculate gross margin as a percentage of revenue:
Gross Margin Percentage = Gross Margin / Revenue * 100
This is valuable because, as explained above, COGS should move with revenue. Therefore, the gross margin percentage should be relatively constant. If there is a significant change, say from 40 percent in one period to 20 percent in the next, then it should be a red flag. While there can be completely valid reasons for such a change, it is important to understand what is going on.
6. Dollars spent on SG&A should be relatively constant
One final thing to keep an eye on are the dollars you are spending for SG&A. This number should also be reasonably constant. A significant change in the dollars you are spending on SG&A should also be a red flag that causes you to dig a bit deeper to understand what is happening in your business.
