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  • In this video you'll learn what an income statement is.

  • 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