In this lesson, we’ll be covering some of the key steps in preparing an income statement. We’ll also take a look at all the items that are usually listed in the statement, especially when it comes to e-commerce businesses.
Steps in preparing an income statement:
Start with Revenue
The first thing you need to start with is revenue. This is the net amount your business has earned in sales, prior to making any deductions. Once you have this amount, you can calculate your gross profit for the period.
Calculate Gross Profit
Gross profit is the profit that remains once you deduct all direct costs related to selling the product such as credit card processing fees and shipping charges.
It is calculated using a simple formula, as given below:
Gross Profit = Revenue – (Cost of Goods Sold & Other Direct Expenses)
Calculate Operating Profit / Net income before interest, taxes and depreciation.
You arrive at operating profit by deducting overhead expenses from the gross profit. Overhead are all non-direct expenses that are required to run the business. These include things like internet service, salaries, web hosting etc.
Operating Profit = Gross Profit – Overhead Expenses
What to exclude from operating expenses :
All interest expenses will be excluded from operating expenses because they are not an essential part of running the business. That is, even though it is used to finance the business, it doesn’t directly impact the business’s ability to turn a profit.
The operating income should be free of any non-recurring or unusual expenses.
One of the most important things to note is that even if you have great sales, your business can still be on a fast track to failure if you don’t keep your operational expenses in check. Any discrepancies can be spotted with a thorough analysis of the income statement.
Should taxes be deducted?
Taxes are a rare sight on ecommerce business statements. This is largely because the venture will be set up as an LLC (Limited Liability Company) or an S-corp. This means that the income goes straight to the owner’s personal income statement to be taxed. Since these rates will vary from person to person,they are rarely included in the company’s income statement.
What else to calculate :
Gross margin helps you know how capable your company is of controlling direct costs.It is a healthy sign if this number is steady or increasing.
It can be calculated as follows:
Gross margin = Gross profit/ revenue
Operating margin helps you know how well your business is handling all of its operational costs, including overhead. This is very important because it helps you spot unhealthy margins, even when you may have high revenue.
It can be calculated as follows:
Operating margin = Operating Profit/ Revenue
What a basic income statement is made of: some key terms
The sales figure is what we call revenue.It is the amount that flows into the business, after you deduct product returns and discounts
These are the direct costs related to production of goods. Eg: If you own your production unit for an online T-shirt store, this will include all the production costs.
It is calculated by deducting the cost of goods sold from revenue (net sales).
These are the day-to-day expenses incurred in running the business. They broadly cover aspects such as selling, marketing and general administrative expenses.
The salaries paid to your sales staff inclusive of bonuses and commissions.
Collateral and promotions
These include product samples and giveaways that help promote your business. This covers your advertising spend for the term, across all media.
These are other costs related to sales such as travel, client meetings etc.
Charges incurred in renting or leasing your office space are included in expenses.
Utilities is a broad term that covers heating, air conditioning, internet, electricity and other costs related to running your business.
Once you deduct the operating expenses from the gross profit, you arrive at a figure called the net income.
Total Expenses are a list of all the expenses incurred in running the business, such as the ones mentioned above. This will exclude taxes and interest related expenses.
Depreciation is the annual decrease in value that’s charged on equipment your business owns. In an income statement where EBITDA is calculated, depreciation is added back.
Difference between Revenue and EBITDA
Revenue is the top line of the income statement and it includes all the income generated by the business from net sales, prior to deducting expenses. These include cash and accrued income.
What is accrued revenue?
Accrued revenue means that the income is added to the statement when the sale is made, even if the payment is yet to be received.
Revenue sources may vary for a business. It could be from product sales, service fees, rent or something else entirely.
Basically, any money that flows into the business during the period is termed revenue. It primarily indicates the business prospects. A decrease in revenue can lead to a decrease in net income.
Earnings before interest, taxes, depreciation and amortization is a bottom line that is calculated only when a business is valued above 10 million USD. So basically, a fairly large ecommerce business with multiple stakeholders. The metric is used to evaluate the company’s earning power, ie; its profitability.
EBITDA precisely measures the business performance and almost always portrays the actual earnings of a business prior to no operating expense deductions and accounting.
Simply put, EBITDA is a valuable tool used to determine how capable a business is to generate cash flow from its activities.
Investors and lenders use an EBITDA to determine the company’s ability to pay off bills and generate net income. It is also used for comparing the performance of your own business to another.
So far, we’ve covered the simple steps on calculating an income statement, general items that are listed and some of the key terms you’re likely to come across. In the next lesson we’ll take a look at different types of income statements and show you how to analyze them.