How to read an income statement: What every business owner needs to know

One of the most basic of indicators of the health of any business is its financial statements. I’m not saying they are the be-all-end-all. There are lots of other indicators we should look at in addition to the financial statements; but it’s hard to argue that you are fully in control of your business if you don’t understand your financial statements, especially how to read an income statement.

how to read income statements

And yet, many business owners don’t have a very complete understanding of what their financial statements are telling them. Many can read the income statement (sometimes called the P&L), but most don’t really get the balance sheet and forget the cash flow statement — hardly anyone even looks at that! (Though everyone looks at their checking account balance, which gives them part of that picture.)

If you have no familiarity with accounting or financial statements, it is worth it to take a couple of days and invest in a class. Almost any executive education provider has a class called something like Finance for Non-Financial Managers that will likely provide you with all the detail you need to get some good insight into your business’ financial statements. The American Management Association has one, your local university likely has one in their executive education department, and there are even private providers who teach it. That’s the quickest easiest way to go from zero to competence, and you need at least competence.

For those who at least know assets from liabilities, and understand accrual versus cash accounting, we’ve got a few tips to help you get more out of your financial statement review. Today we’ll look how to read an income statement; tomorrow we’ll tackle the balance sheet!

Use Ratios

When I read an income statement I usually don’t spend my time going line by line and scrutinizing every number. I start with the big numbers and compare them to other businesses I’ve seen. To do that I use ratios. Think of your gross income (sometimes called “Sales”) as $1.00. If your profit is 20% of sales then for every $1 in income you are keeping $0.20. Where is the other $0.80 going? If you have a service business I’m guessing that $0.40 – $0.50 is going to salaries, $0.10 – $0.15 is going to rent, etc. If your salaries are way more than 50% of revenue I’m going to get concerned. So I don’t have to look at each line to see where the money is going. I can start with the big ones and see what they look like as a percentage of sales.

There are a lot of places that publish benchmarks ratios for different industries. Start with your industry trade association or magazines in your industry. Your accountant might also have access to some of those ratios.

Look for Trends

how to read an income statementOne easy way to focus in on what’s happening in your business is to compare your current financial performance with prior periods to see how things are changing. Are sales growing or shrinking? As sales grow (or shrink) how do my expenses change — do they grow or shrink with sales, or do they stay pretty steady?

To accomplish this, we want to look at our income statement with columns by month. Then we can compare the numbers for March with similar numbers for January and February. For businesses that have a lot of seasonal variation it can be more revealing to compare last month’s numbers with the same month from last year. So we would compare March 2013 to March 2012 to see that the trends are.

As you run your finger across the months what do you see? Does one month stand out? What happened there? Is there a trend in a particular direction? What’s causing that?

An even more telling way to display the data is using Trailing Twelve Month Charts which treat every month as the end of a year and compare the sales (for example) from April 2012 through March 2013 with the sales that occurred in March 2012 through February 2013. By comparing only 12 month periods it averages out any seasonality and shows you truly the trend in your business.

Project them forward

To see if you really have a handle on reading your income statement, start playing some “what if” games by projecting forward into the future. If you can’t predict your income you can’t control it. So start by forecasting sales. What causes sales in your company? What actions are you taking that make sales happen? How frequently do they happen? By looking at those things you can start to project your future sales.

Then start to project your future expenses. Ask the same question, what causes expenses. Some just happen, like rent. Others are a function of the number of people you have (like the phone bill, or office supplies) still others are a function of your level of sales (like travel or commissions).

If you get all this together, you can really start to gain some insight into your business. You can start making decisions based on the numbers (like, “What happens if I hire someone?” or “How much would I have to grow sales to maintain my current income if my rent goes up?”) Pretty soon you will find yourself loving your numbers!

Understanding your business financial statements is one way you can have more control over, and more success with, your business. If you look at these numbers regularly I guarantee it will change your thinking and decisions in a way that will cause you to make more money!

Feeling a little overwhelmed?

If any of this seemed a little overwhelming, it’s okay. There’s a learning curve to reading income statements and other financial statements — but the pay off is huge! We have a helpful kit for business owners to help them with their financial statements called our Ultimate Small Business Budget Kit. It has an ebook, 8-step video tutorial that walks you through the whole thing, and a sample pre-formatted Excel spreadsheet with all your financial statements to get you started. You can check it out below:

Photo credit: kenteegardin

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