The income statement: from sales to net profit

The income statement: from sales to net profit

After a month of work, the owner of a business asks two questions. The first one is simple: how much did I sell? The second one is the one that really matters: how much did I actually earn? They are different questions. Selling a lot does not guarantee earning a lot, and there are months when sales go up and yet the business pocket ends up almost the same. The income statement, also called the profit and loss statement, is the accounting report that answers the second question, because it shows, in an orderly way, how the report goes down from the total sales of the period to the final net profit. Along with the balance sheet, it is one of the documents every owner must learn to read, and that is why this lesson of the accounting manual explains what it contains, how it is built level by level and what every line means.

To understand its value, think about what happens when the business sells merchandise. The cash register receives the full price the customer paid, but that money is not profit: an important part of it belongs to the value of the merchandise that left the storeroom and that the business had to buy before, another part belongs to the expenses of the month, such as rent, salaries and utilities, and another part corresponds to the taxes recognized on profit. If the owner looks only at the money that came in, he may believe he is earning when he is barely recovering what he had already invested. The income statement separates those parts and shows how much of the money from sales becomes real profit at the end of the period.

Sales, returns and discounts: net sales

The statement is built like a staircase that goes down from the most general to the most concrete, and it starts at the top, with the sales line. There, the business records the total revenue from the merchandise delivered to customers during the month, whether they paid in cash or they still owe on credit. In accounting, revenue is recognized when the business does its part, that is, when it delivers the merchandise, and not when it receives the money; in that way the statement reflects the real activity of the period and not the accidents of payment dates.

Two concepts are subtracted from that total. The first one is returns, which happen when customers bring merchandise back because it was damaged, because it was not what they ordered or for any other reason agreed with the business. The second one is sales discounts, which are price reductions granted on the sale, either at the moment of selling, through promotions or for early payment. The result of that subtraction is the net sales line, which is the fair figure against which everything else is compared. Selling $18,000,000 and then returning $500,000 is not the same as selling $17,500,000 net: discounts and returns are lower revenue, and if they are not subtracted, the statement shows more activity than there really was.

The cost of sales and the gross profit

The next step subtracts the cost of sales, which is the value of the merchandise that was actually sold during the period. It is not the price at which it was sold, but the cost at which the business bought it or made it ready to sell. It is the same concept studied in the previous lessons of the manual: under the periodic system it is worked out with the formula of beginning inventory plus purchases of the period minus ending inventory, while under the perpetual system it is accumulated product by product with the help of the stock card, the kardex. When the business records every entry and every exit by product, as it is done with Kardex Tauro, the cost of sales of the month comes directly from the accumulated record of the exits, without waiting for the physical count to know how much merchandise was sold.

By subtracting the cost of sales from net sales, the gross profit is obtained. This is the first important result of the statement, because it shows how much the business earns from its inventory: how well it buys, how well it sets its prices and how much merchandise it loses, damages or lets expire. If the gross profit is low, the problem is at the heart of the business, because it may be buying at high prices, selling too cheap or neglecting its storage, and no adjustment of expenses will fully fix a margin that is born wrong at the purchase or at the price.

Period expenses and the operating profit

Below the gross profit, the period expenses are subtracted, which are different from the cost of sales because they are not linked to a specific item of merchandise but to the operation of the business during the month. They are grouped into two families. Administrative expenses include the rent of the store, the salaries of the administrative staff, utilities, stationery and cleaning. Selling expenses include advertising, sales commissions, the salaries of the sales staff and the delivery transportation of the orders. Both are necessary, but both must be kept under control, because they are consumed month after month without leaving a tangible product that can be resold.

By subtracting the period expenses from the gross profit, the operating profit is obtained, which shows how the business is doing in its normal activity, before the effects of financing and taxes. This level is the picture of expense control: if sales go up but expenses go up just as fast or faster, the operating profit does not improve, and two businesses with identical sales can have very different operating profits if one manages its expense structure better.

Financing costs, taxes and the net profit

Then come two subtractions that depend on the particular situation of each business. The first one is financing costs: the interest on loans and credits, bank fees and other costs of financing, which exist only when the business borrows money or uses financial services. The second one is the taxes on profit, which are recognized when the period leaves a profit and which are calculated according to the rules in force and the conditions of each business. In this lesson we treat them only as a general concept, without rates or percentages, because every country, every year and every specific case has its own rules, and the exact figure must always come from the accountant of the business.

After subtracting those items, the net profit remains, the last line of the statement and the direct answer to the question we started with: how much the business really earned during the period. It is the figure the owner can reinvest, save or withdraw, always with good judgment and after reviewing the cash needs of the business, because, as we will see later, profit and available money are not the same thing.

The income statement of the hardware store in one month

To make everything clear, let us suppose a neighborhood hardware store that sells paints, tools, cement and building materials. During one month, the business billed $18,000,000 in sales. Some customers returned merchandise worth $500,000, so net sales were left at $17,500,000. The cost of the merchandise sold, calculated with its inventory stock card, was $11,000,000. Administrative and selling expenses added up to $3,200,000, distributed among the rent of the store, the salaries of the two employees, utilities, neighborhood advertising and the transportation of the orders. Finally, the business recognized $800,000 for taxes on profit for the month. The complete statement looks like this:

Read it from top to bottom like a staircase. Between sales and net profit there are $15,500,000 that did not stay in the business: $11,000,000 were the cost of the merchandise sold, $3,200,000 were the expenses of the month, $800,000 were the taxes on profit and $500,000 were the returns to customers. Only $2,500,000 were real profit. If the owner had looked only at the $18,000,000 in sales, he would have believed he earned much more than he actually did, and that is exactly the kind of mistake this statement helps to avoid.

What each level of the statement reveals

Each level of the statement answers a different question about the health of the business, and it is worth knowing which one is which so you do not look for the problem in the wrong place:

• Gross profit talks about the inventory business. It shows how well the business buys, how it sets its prices and how it takes care of its merchandise. If this level is weak, the problem is in the purchase, in the price or in the management of the inventory, not in the expenses.
• Operating profit talks about expense control. The distance between gross profit and operating profit is exactly the cost of keeping the business open and running: store, people, services and advertising. If that distance grows month after month, the business is spending more and more on its structure.
• Net profit talks about what is left at the end. It is the figure on which decisions are made: how much can be reinvested in merchandise, how much can be saved for difficult times and how much really reflects the effort of the month.

With that reading, an owner can react with precision: if the gross margin is fine but the net profit is low, he must review his expenses and his financing; if the gross margin itself is low, he must review his purchases and his prices before anything else.

Three common mistakes when reading the statement

Even with the statement in hand, there are typical mistakes that lead to wrong conclusions. The three most frequent ones in small businesses are:

• Looking only at sales. Celebrating a record month without reviewing the profit is dangerous: a month with $18,000,000 in sales can leave less profit than a month with $12,000,000 if the cost of sales or the expenses went up in the first one. The sale is the beginning of the story, not the end.
• Forgetting the cost of sales. Treating every outflow of money as an expense of the month confuses the statement. The merchandise that is bought is not an expense until it is sold, and the cost of what was sold must be subtracted to reach the gross profit, not mixed with rent and advertising. Whoever forgets this line believes he earns more than he really earns.
• Mixing personal expenses with business expenses. Paying the household groceries with the store cash and including them in the expenses inflates the expenses, reduces the profit and paints a false picture of profitability. The statement must reflect only the life of the business; the family and the business are two separate pockets, even when they sometimes share the same person.

Profit is not cash

Perhaps the most serious reading mistake is believing that the net profit is money the business has available in the cash register or in the bank. It is not, and understanding that difference saves you from more than one disappointment. The income statement records economic events when they happen, not when money comes in or goes out: a credit sale of $2,000,000 increases the profit of the month even if the customer pays within thirty days, and a purchase of merchandise of $4,000,000 paid in cash reduces the cash today but does not touch the profit until that merchandise is sold. There are even expenses that do not require paying anything during the month, such as the depreciation of a tool, and payments that are not expenses, such as the principal payment of a loan.

That is why a business can show profit and at the same time have trouble paying its bills, or it can be short of cash for a month and still be profitable. To know how much money is really available, you have to review the cash flow statement, which is studied in a future lesson of this manual. In the meantime, keep this idea: profit measures the result of the period, not the cash of the business, and each of those two reports answers a different question.

Simple indicators to accompany the statement

The absolute values of the statement help, but percentages allow you to compare one month with another, one year with another and one business with another similar one, without the size of the operation distracting you. Three simple indicators are enough to start reading the statement of the hardware store in the example. All of them are calculated on the net sales of the period, which in this case are $17,500,000, and they are didactic figures, with no fiscal or regulatory value:

The beauty of these indicators is that they allow you to see where the business is heading. If the gross margin goes down from one month to another, the problem is in the purchase or in the price; if the gross margin holds but the net margin goes down, the problem is in the expenses, in the financing or in the taxes; and if the expenses over sales keep going up, the structure of the business is becoming more expensive than the sales can support. No percentage replaces the judgment of the owner, but all of them help him ask better questions.

Important closing note for this lesson: the numbers in this example are purely didactic, and the taxes on profit are mentioned only as a general concept, without rates, percentages or particular rules. Every business has its own reality, its own legislation and its own conditions, and the exact figure of each line must come from its records and from the review of its trusted accountant. The purpose of this manual is for you to understand the income statement, to read it level by level and to be able to ask your accountant the right questions about the profit of your business.