As a self-employed business person, there are three key financial documents you need to understand: the balance sheet, cash flow statement and income statement. This article will focus on the income statement.
To help you understand this very important document, this guide will cover:
- What is an income statement?
- Why is an income statement important?
- What do I need to include in an income statement?
- What are the different types of income statements?
- How do I create an income statement?
- How Countingup can help
What is an income statement?
An income statement is a financial document you fill in to report your company’s income and expenses to HMRC (HM Revenue and Customs). In other words, you use an income statement to tell HMRC how much your business made and spent in a specific time period.
An income statement also shows whether your company is making a profit (making more money than you spend) or loss (spending more than you make) during that time. This is why it’s also referred to as a profit and loss statement.
Why is an income statement important?
An income statement helps you understand how your business is doing financially. You can see where your business strategy is effective and where there’s room for improvement. This knowledge can help you come up with new techniques to increase your business’ profits.
Since income statements are created monthly or quarterly, business owners and investors can use them to track the company’s performance closely. Tracking your performance helps you make informed decisions. You can also use this statement to find and fix small business problems before they become large and expensive.
The income statement also highlights where your business spends the most money, including which expenses may be under or over your budget — for example, building rent, utility bills and software subscriptions.
This document also helps predict any future expenses you may have, like buying supplies or promoting the business. You can use this information to plan ahead and make sure you have enough money to cover these costs.
Finally, your income statement gives investors an overview of the business, so they can determine if investing in it is a good idea. Banks and other financial institutions, like lending companies, can also use it to decide if you’re worthy of a business loan.
What do I need to include in an income statement?
The information listed on your income statement will vary depending on your chosen format and specific details about how your business operates.
However, below we’ve listed some common items you can include in your income statement:
- Revenue or sales: Money you earned through selling your products or services. This will be the first section of the income statement.
- Cost of goods sold: Total direct costs from selling your products and earning revenue, including the cost of work and materials.
- Gross profit: Calculated by subtracting the cost of goods sold from your revenue. You’ll only find this equation on the multi-step income statement.
- Advertising and marketing expenses: Costs connected to marketing your business to attract clients or customers, including paying for digital or print advertising.
- General and administrative expenses: The admin costs linked to running your business, including rent, supplies and travel expenses.
- Earnings before tax: This is your pre-tax income and usually the second-to-last item included on an income statement.
- Net Income: Total revenues minus total expenses. Net income is the last listed item on an income statement. If you subtract your total expenses from your total revenue and get a positive number, your business made a profit. If the number is negative, you made a loss during that period.
What are the different types of income statements?
You can create an income statement monthly, quarterly or annually, following one of two reporting formats:
Single-step income statement
This format gives a simplified record of your business’ financial activity, only using one step to calculate net income. Sole traders and small business owners generally prefer this method since their daily operations are relatively simple. The single-step income statement is straightforward and still gives them the relevant information they need.
Use this equation to determine net income for a single-step income statement:
Net Income = (revenues + profits) – (expenses + losses)
Multi-step income statement
The more complex of the two formats, offering more detail about a business’ financial activities by separating operating revenue and expenses from non-operational ones. Operating revenue and expenses are what you make and spend while running your business day-to-day.
Non-operating revenue and expenses aren’t directly related to your daily activities, such as profits, losses and dividends (profit shares you pay to shareholders).
The multi-step income statement uses three steps to calculate the net income:
- Gross profit = Net sales – Cost of goods sold
- Operating income = Gross profit – Operating expenses
- Net income = Operating income + Non-operating items
Separating the two types gives business owners a better picture of how your company’s core business activities drive profits. However, multi-step income statements are used mainly by large corporations with complex business operations.
How do I create an income statement?
Countingup has a free downloadable template you can use to create your income statement. If you’d prefer to build yours from scratch, we have a separate guide on how to prepare an income statement.
Make it simple to keep on top of your finances
Countingup is the business current account and accounting software in one app. It automates time consuming financial admin so that you can focus on running your business. With instant invoicing, automatic expense categorisation and cash flow insights, you can confidently keep on top of your business finances everyday. Find out more here.