I'll show you what it looks like and how you can use it to

measure a business's financial performance.

[Music]

Hey there

welcome back to Accounting Stuff I'm James and in today's video

we're going to cover the income statement

also known as the profit and loss statement or the P&L

for short. This is one of the three major

financial statements in accounting along with a balance sheet

and the cash flow statement. Collectively these reports

give us an impression of a business's financial health

so it's important that we understand how they work.

I've already made videos covering the balance sheet and the

cash flow statement which you can find linked up here and

down below in the description. But up until now I haven't posted

a video yet on the income statement and I've received a lot of requests

from you guys to cover this topic so thanks for all these

particularly from one subscriber so Niloy, if you're watching

this video goes out to you good luck in your exam

hope you crush it! An income statement is the

summary of a business's revenues and expenses over a period of time.

In its basic form an income statement looks like this.

It's a summary of a business's revenues and expenses

over a period of time. When we take our total revenue and

subtract our expenses from it then we work out our profit or our loss.

We make a profit when our revenues exceed our expenses

and on the flip side we make a loss when our expenses

are more than the income we've earned. This is why the income statement

is also known as the profit and loss statement or the P&L

for short. It lays out a roadmap for how we

ended up here at the bottom line

our profit or loss. The income statement

always covers a period of time which could be anything that we

want it to be but typically we run it for a month

a quarter or a full year. Here's a helpful analogy

that I read in this book the accounting game

which I recommend reading if you're new to accounting

you can find my review of it up here. Anyway back to it.

If a balance sheet shows us a snapshot of a business's assets

liabilities and equity at a single point in time then you can

think of it as a photograph or a still frame taken from a video.

Whereas the income statement covers a period of time

it's like watching a clip of that video it has a beginning and it has an end

and if we look at it carefully and analyse it then it can tell us a story

but more on that later. Let's take a closer look at our

income statement. Revenues less expenses

make us a profit or a loss. The problem with this layout

is that it doesn't give us much detail it would be much better

if we made things a little more descriptive for instance

revenue there are many different types

of revenue. If we were running a business that sells

physical products then we might want to call this product sales instead

or if we provide services we can call this our services rendered.

This extra detail helps the readers of the income statement

better understand what they're looking at. Clarity is the aim of the game here.

The same goes for expenses businesses typically incur many

different types of expense but broadly speaking these can be

broken down into two categories our direct costs of doing business

and our indirect costs of running the business. Our direct costs of doing business

are the costs which we can directly trace through to the products

we've sold or the services that we've provided.

For a business that provides services we might call this our cost of services

and if we sell physical goods then we can call this our cost of sales

or our cost of goods sold. Direct costs like these are variable costs

which increase in direct proportion to the sales that we've made.

If you were running a retail or a wholesale business

then these would include things like the original purchase price

of the product that you're reselling or if you've run a manufacturing business

then this would include the cost of your raw materials

or the direct labor cost that went into producing your product.

As we make more sales we incur more of these direct costs.

Cost of goods sold can be a bit of a tricky concept to

understand at first. It ties in very closely with inventory

in the balance sheet. If you'd like to see me make a video

explaining how all of that works then let me know

down below in the comments and if you haven't already

remember to hit that subscribe button so you don't miss out on all of

the other accounting tutorials that we have coming out very soon.

Back to the income statement. When we take our revenue and

deduct our direct costs of doing business

we get to our gross profit. If you're new to accounting

then you'll soon discover that we have many different types of profit.

Our gross profit is a really useful tool that allows us to measure

the efficiency of our production and sales process.

I'll show you how that works in a minute

but first let's jump back to indirect costs. These are the costs

of running a business which can't directly be traced back

to the production of goods or the provision of services.

We sometimes call these overheads. Overheads can include fixed costs

like rent employee salaries

insurance costs admin expenses

legal costs accounting costs

marketing costs depreciation and amortisation

there's a lot of them! Fixed costs like these

tend to remain the same they bear no correlation at all

to the sells that your business has made. However not all overheads are fixed.

Variable overheads can loosely correlate with a business's sales

although they can't be directly traced back to the production of goods

or the provision of services. These include things like

advertising costs which can indirectly drive sales

and sales commissions. Utility costs could also be considered

a variable overhead in a manufacturing business

because these can increase as we ramp up production.

When we deduct our indirect costs of doing business from our gross profit

we come to our operating profit. Operating profit measures the

net income that we've generated from operations

this is the residual amount that's left over after deducting

all of our direct and indirect costs of doing business.

So this is our basic income statement but how does it help us measure

a business's financial health? It does that by giving us a means

to compare our financial performance against comparative accounting periods.

A comparative period is a different period of time.

It can be whatever we want it to be we can compare

a current month income statement against last month's income statement

or this year versus last year. When we use comparative periods

we can calculate the change or movement across each line item

down the profit and loss statement and as accountants it's our job

to support these movements with a narrative which explains

all of the differences. Let's throw in some numbers

into an imaginary company and I'll show you what I mean.

We'll compare the movements in our P&L year-on-year.

This is going to be for a medium-sized business

so we can quote our numbers in thousands of dollars.

What have we got here? Our imaginary company

has made sales of a hundred and ten thousand dollars

which is up ten thousand dollars from what we made in the prior year.

Our cost of goods sold have also increased by

ten thousand dollars from $30,000 to $40,000

that's left us with a gross profit of seventy thousand dollars

which has remained unchanged. Our overheads are fixed

at forty five thousand which gives us an operating profit

of twenty five thousand dollars in each period.

What can we learn from all of this? Well our sales have increased

by ten thousand dollars but our gross profit has remained exactly the same.

How can that be? A useful metric that we can use

to analyse this is gross profit margin. We can calculate our gross profit margin

by taking our total product sales and deducting our costs of goods sold

and then dividing the whole lot by our product sales.

This measures how efficiently we've been producing and selling

our imaginary product. In this case our gross profit margin

in the current year is around 64% which is actually down

from last year's gross profit margin of 70%. How is that possible?

Well one of two things could be happening here.

Our sales can be shrinking or our costs could be rising.

We could be selling more products but at a discount

or the cost of our raw materials could be rising.

These are the questions that we need to be asking ourselves

as accountants investors or small business owners.

We can compare metrics like the gross profit margin

across comparative periods to help us identify what questions

we should be asking and then that's when the work begins.

We need to find out the answers and use them to build a narrative

that explains what's going on. Gross profit margin is just one of many

business metrics that we can use to analyse the income statement.

If you'd like to see me make videos on the others let me know.

Now this is still quite a basic income statement.

In reality there are other indirect costs of doing business which we might

need to include as well. Things like interest expenses and tax.

These tend to slot in below operating profit

because they aren't considered to fall within the normal

cost of operations. This is why operating profit

is also known as EBIT or earnings before interest and tax.

When we deduct interest in tax from

our operating profit we calculate our net profit

the bottom line because it's at the bottom

of the profit and loss statement. So you can see that there are many

different types of profit and loss to consider in accounting.

We start off with our revenue and we deduct our direct costs

of doing business to come to our gross profit

our top-line profit. Below this we take out

the indirect costs of running our business to find our

operating profit our EBIT

our earnings before interest and tax and when we remove interest and tax

we calculate our net profit the bottom line.

Together these different types of profit help us measure

performance over a period of time. The main goal of most businesses

is to maximise their profits so it's important to be clear

on what that means and to be aware of the differences

between gross profit operating profit and net profit

which can each tell us a different part of the story.

Like I mentioned earlier the income statement is just one

of the three main financial statements along with the balance sheet

and the cash flow statement. I've made videos covering

both of these already which you can find here and here.

If you found this one useful give it a like

or better yet share it with a friend

why not? Don't forget to subscribe

for more accounting tutorials! I'll see you round.