Understanding Your Income Statement: A Guide for Small Business Owners
Financial statements can feel like a foreign language to many small business owners. If you’ve ever stared at an income statement and wondered, “What does this all mean?” - you’re not alone. But here's the thing: understanding your income statement is one of the most empowering steps you can take to grow your business.
We wrote this blog to explain what matters in your income statement and how to interpret it yourself. We’ve also created something exciting: The Financial Statement Workbook (available in both Microsoft Excel and Google Sheets), which will help you analyze your numbers like a pro.
What Is an Income Statement and Why Does It Matter?
Think of your income statement as the story of your business’s financial performance over a specific period. It’s like a report card, showing whether your business is making or losing money. This document breaks down your revenue, costs, and expenses, ultimately revealing your net profit (or loss).
Let’s simplify it with an analogy:
Revenue is like the money you earn from babysitting or mowing lawns as a kid.
Expenses are the costs of your tools - like gas for the lawnmower or snacks to keep you going.
Profit is what’s left in your pocket after you’ve covered your costs.
Many business owners focus solely on their sales numbers without considering the bigger picture of profitability. However, tracking profitability is key to understanding whether your business can sustain itself and grow over time. For example, if your revenue is increasing but your expenses are rising just as quickly, your business might not be as healthy as it seems.
Additionally, your income statement can provide insights into your seasonal trends. If you run a business that experiences fluctuations - like a retail store that sees spikes during the holiday season - tracking your income statement over several months can help you plan better for slow periods by setting aside profits during peak times.
Understanding this breakdown isn’t just for accountants; it’s a vital tool for business owners to spot trends, identify opportunities, and make informed decisions. For example, knowing that your revenue is only just covering your costs can signal that you either need to raise your prices, or reduce your expenses in order to increase your profits.
Components of an Income Statement
Revenue
Revenue represents the total income your business generates from its core operations. It’s the top line of your income statement and includes:
Product sales (e.g., selling handmade candles).
Services rendered (e.g., consulting or photography).
Why it matters: Tracking your revenue helps you understand whether your business is growing and how well your offerings resonate with customers. For example, if you created two new candles and one is selling better than the other you know to stock the better selling candle more often or in higher quantities.
Another key consideration with revenue is understanding the difference between gross revenue and net revenue. Gross revenue refers to the total sales before any deductions, while net revenue accounts for discounts, refunds, and other reductions. Monitoring both figures can help you assess pricing strategies and customer retention efforts effectively.
For example, if your gross revenue remains steady but net revenue is declining, it may indicate a high return rate or excessive discounting that’s cutting into your profits.
Cost of Goods Sold (COGS)
COGS is the direct cost of producing or delivering your product or service.
Examples of COGS include:
For a candle maker: wax, wicks, and packaging.
For a graphic designer: software subscriptions and contractor fees.
Tracking COGS regularly can help you identify cost-saving opportunities. For instance, if your supplier costs have increased, it might be time to renegotiate contracts or explore alternative vendors. Additionally, evaluating your production efficiency - such as reducing waste or optimizing workflow - can also contribute to lowering COGS and improving overall profitability.
It's also important to distinguish between direct and indirect costs. Direct costs are those directly tied to production, like raw materials, while indirect costs - such as utility bills for the production facility - are considered operating expenses rather than COGS (sometimes also referred to as overhead).
How it affects your business: COGS determines your gross profit, which is revenue minus COGS. As your cost of goods sold increases, your profits decrease and might signal that you need to revisit pricing or supplier costs.
To learn more about COGS check out my blog ‘Navigating Your Costs: A Closer Look at COGS for Entrepreneurs’.
Expenses
Expenses cover all the other costs involved in running your business. These typically fall into two categories:
Operating expenses (needed to run the business): Examples include; Rent, utilities, salaries, and marketing.
Non-operating expenses (the result of having a business) : Examples include; Interest on loans or unexpected losses.
A quick tip: Reviewing expenses regularly can help you identify areas where you might be overspending or opportunities to cut costs. Cutting costs is much faster than acquiring new clients. Check out our Financial Statement Workbook to make reviewing your expenses much smoother.
Net Income
Net income, also known as the “bottom line,” is what’s left after you subtract all your expenses from your revenue. This number tells you whether your business is profitable, and what your income taxes will be.
Healthy net income means your business thrives, while consistent losses could signal the need for pricing adjustments, cost reductions, or strategy changes.
How to Read an Income Statement
Reading an income statement doesn’t have to be intimidating. Here’s a step-by-step guide:
Step 1: Start at the Top
Look at revenue to see how much money your business brought in during the period.
Compare this number to previous periods to spot trends. Is revenue growing, flat, or declining?
Step 2: Move to COGS
Subtract COGS from revenue to calculate gross profit.
Analyze your gross margin (gross profit divided by revenue). A healthy margin depends on your industry, but it’s a good indicator of efficiency. If it doesn’t align with the standard for your industry, you know it’s a good idea to consider increasing it for new clients/items.
Step 3: Examine Expenses
Review your operating expenses. Are there any categories where spending has spiked unexpectedly? Did you add another subscription for a similar product? Can you get multiple uses from one product (editing video and recording with one app)?
Consider the return on investment (ROI) for discretionary spending like advertising. How many leads did that Facebook ad generate compared to the cost of it?
Step 4: Understand Net Income
Look at the bottom line. Is your business profitable? If not, dig deeper into revenue and expense trends to identify why. Maybe you aren’t charging enough? Or maybe you could find supplies for a lower cost from a different supplier?
Remember: A one-time loss isn’t necessarily bad if it’s tied to an investment that will drive future growth. For example, a second embroidery machine for your fashion business could cut production time in half. Leaving more time for advertising the products with social media content.
Spotting Red Flags
Here are a few common issues to watch for:
Declining revenue despite increased marketing efforts. Are the markets you’re attending worth the booth fees?
High COGS eating into gross profit. You need to ensure that the price you’re charging covers both the materials used and a profit margin.
Rising expenses without a clear explanation.
Another common red flag is a sudden increase in customer returns or refunds. If your return rate is climbing, it could point to issues with product quality, customer satisfaction, or misleading marketing. Addressing these issues early can prevent revenue loss and reputational damage.
Additionally, if your revenue is growing but your profit margin is shrinking, this could indicate rising operational inefficiencies or hidden costs that need to be addressed through process improvements or better financial oversight.
These could indicate inefficiencies, pricing issues, or the need for better expense management.
Conclusion: Take Control of Your Numbers
Your income statement is more than just a report - it’s a roadmap to your business’s financial health. By understanding its components and what they mean, you’ll gain valuable insights to drive smarter decisions.
If you’re ready to take action on your business finances and finally get to reviewing your income statements in less time and with less anxiety, you can pick up our Financial Statement Workbook.
Still, have questions and/or need support?Click here to reach out! Or if you’ve already hit buy for your new Financial Statement Workbook, share some of your results with us on social media and tag us on IG, Linkedin, TikTok, or Youtube.