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Businesses are financial entities. The language spoken by businesses is that of the financial world (i.e., banking, insurance and accounting), and financial statements are the way to inform others about the business and its success.
Businesses Are Started to Make Money (Profit).
The first and most important financial report is the Income Statement.
The Income Statement is also called the Profit and Loss Statement or the Statement of Income and Expenses.
The term Income Statement is the most common name in use today to describe this report, so Income Statement will be used throughout this section.
The source of funds that a company receives in exchange for delivering its products or services to customers is called revenue. These funds for a business are also referred to as gross income or sales.
To avoid confusion, revenues will be referred to as funds derived by selling products or services, and income will be used to describe the result or profitability of the business when customers pay for the product or service.
The example below will assume that all payments to the company will be in the form of cash or check. The company will record its receipt of cash from its customers in its Cash Receipts Journal.
Figure 5 Displays the receipts journal for a landscaping company called Joe’s Landscaping,Inc.
While the majority of the entries recorded into this journal show payments from customers, there are a few non-operational sources recorded, too.
This distinction is important because the Income Statement deals primarily with the revenue of the business operation.
The non-operational items are analyzed in a different financial statement.
Figure 5
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Raymond Nowicki, CPA sums up the rationale for preparing financial reports in this manner, “Financial statements are the means for businesses to communicate with owners and the outside world.”
Expenses
Expenses are the cash outflows from a business (cash spent) in the day-to-day operations of a business.
Expenses include the costs of materials, labor, supplies and services used to produce revenue.
Businesses record transactions relating to expenses in the Cash Disbursements Journal.
Figure 6 displays the Disbursements Journal for Joe’s Landscaping, Inc.
The Disbursements Journal shares the characteristics of the Receipts Journal in that operational and non-operational items are recorded.
For the purposes of the Income Statement, the operational items (those expenses related to day-to-day operations) are required for the analysis.
The Income Statement follows this format as you will see below:
Revenues - Expenses = Income or Profit
Figure 6
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Income statements are designed to report the business results of operations over distinct periods of time. The most common time period represented by income statements is one year. However, statements can represent quarterly, six-month or even monthly periods.
The time period represented is important because businesses experience seasonal fluctuations or may see short-term results of one program or advertising campaign.
The length of time of the income statement helps the reader understand the information. The time factor is important for the income statement.
Cost of Goods Sold
When businesses manufacture products before selling them, or if the business has a lot of inventory, Cost of Goods Sold analysis further describes the expenses for the business.
Specifically, the Cost of Goods Sold analysis measures the direct costs of producing the goods or services sold to the customer.
The calculation of the Cost of Goods Sold follows this simple formula:
Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold
For more complex businesses, further analysis requires knowing the cost of materials, labor and overhead attached to the units sold.
However, the relatively simple structure of Joe's Landscaping, Inc. requires only the inventory analysis.
In our example, the Income Statement is for the month ended July 31st, 2xxx. The figure for Beginning Inventory is the amount on the Balance Sheet for "Inventory" as of June 30th, 2xxx. (The Balance Sheet will be discussed in a later section.)
To calculate the dollar figure for Purchases for Joe's Landscaping, Inc., add the totals of the first three columns of the right hand side of the Cash Disbursements Journal.
Ending Inventory is often calculated by physically counting the items meant to be used in creating the goods (or providing the services) still on hand, and adding the costs paid for such items.
(Note: An actual count of inventory, at least once a year, should be done to check on theft or damaged inventory. This is referred to as shrinkage.)
When the Cost of Goods Sold is calculated as part of the Income Statement, a separate calculation of profitability based only on direct costs can then be made.
This item is called Gross Profit, and it is calculated from the following formula:
Revenues - Cost of Goods Sold = Gross Profit
This calculation measures the efficiency of production of the goods or services.
Mr. Armand Mastroianni of Mastroianni Brothers Baking Company says,
“I monitor flour and labor costs (the two largest expense categories) on a weekly basis to track the two largest costs in bread production”.
Mr. Mastroianni recognizes that small changes in these two categories can mean the difference between generating a profit or loss for the week.
Bankers are quick to use Cost of Goods and Gross Profits as measures of efficiency.
Most financial analysts use industry averages as a comparison to an individual company. Comparison to industry averages gives the reader a first impression of a business' efficiency when compared to similar businesses.
“Using industry averages from a source like Risk Management Association (RMA), gives me a starting point when reviewing financial reports,” states Mr. Robert Esposito.
Mr. Mastroianni and Mr. Esposito both recognize the importance of cost control in production. Knowing the Cost of Goods Sold and Gross Profit of a business communicates this information to the reader.
Once Gross Profit is calculated, it becomes the basis from which Selling, General and Administrative Expenses are deducted. Depending on the amounts for each, the deduction results either in a net profit, net loss, or break-even for the company.
Selling, General and Administrative Expenses
The other expenses of the landscaping service or any venture are measured in a section of the Income Statement called the Selling, General and Administrative Expenses Area.
This section of the Income Statement is sometimes referred to as Operational Expenses or Fixed Expenses, and can be composed of many categories. This section includes all indirect expenses and other operational expenses of the venture.
Rent, professional fees, insurance, telephone, advertising and office expenses are examples of expense categories in this section. All other expenses associated with the operation of the business are accounted for in this section.
A sample template for an Income Statement is found in Figure 7
Using the preceding examples of Receipts and Disbursements Journals for Joe’s Landscaping, Inc. (Figures 5 & 6), an Income Statement can be formulated using information from these two journals.
For the purposes of the Income Statement, only those entries pertaining to the operational aspects of the business are considered. Cash received for products and services are the only entries from the Receipts Journal used in calculating the Revenues (cash receipts) of the business.
The Cost of Goods Sold and Gross Profit calculations follow the Revenue analysis. In this case, Joe’s Landscaping, Inc. does not carry any inventory. He purchases only that which he needs on a daily basis. Therefore, his beginning and ending inventories are zero.
When calculating purchases of products for use on the customers’ lawns and gardens, Joe finds this information under the first three headings of the right hand side of the Disbursements Journal.
Earlier in this section, the basic categorization of expenses in the Disbursements Journal were outlined in the column headings on the upper right hand side of the page. This means you will total the entries in each column.
Figure 7
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Using the example Cash Receipts and Cash Disbursements Journals in Figures 5 & 6, an Income Statement for Joe’s Landscaping, Inc. would be as follows in Figure 8:
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Information compiled in the Cash Receipts Journal and the Cash Disbursements Journal is useful in analyzing the operation of the business.
Most of the transactions recorded in these two journals relate to the day-to-day operation of the business. The operational “scorecard” for the business is known as the Income Statement and can be developed for any time period you are interested in reviewing.
The categories on the Income Statement measure the revenues generated, the direct costs of sales or services generated (Cost of Goods Sold analysis), and indirect costs (Selling, General and Administrative expenses).
Once these categories (Revenues and Expenses) are developed, the profitability of the business can be calculated.
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