How to Read an Income Statement for Business Owners | Ep 181

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Most business owners look at their income statement but don’t really know what it’s telling them. In this episode, Steve breaks it down so you can see where profit is really made and where it’s slipping away. He explains how to read revenue, cost of goods sold, and gross profit, and then shows you what operating profit reveals about your overhead and efficiency. 

You’ll also learn the three levers that drive profitability and how to use them to improve margins and protect cash flow. If you’ve ever wondered why your sales keep growing but your bank account doesn’t, this episode will give you the clarity to spot hidden profit and make smarter financial decisions. 

Disclaimer:   
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Transcript

Today, I'm going to walk you through how to analyze an income statement so you can look really smart and know exactly where to focus if you want to increase the profitability of a company. Now, the income statement is the most basic financial report, but it doesn't mean that it's not important. Of course, I prefer the balance sheet and the statement of cash flows because those two financial statements give a more comprehensive view of a business, but nonetheless, I'll save those for another episode.

Today, let's focus in on the income statement. So if you're running a business, you have to know the income statement like the back of your hand. Also, if you want to take on a management position one day, understanding how to read an income statement is going to be critical because essentially they'll call you a P&L leader, which stands for profit and loss. You're running the profit and loss of a division, of a geography, of a unit, of a company, whatever it may be. You therefore need to know what's inside this important financial statement. Or perhaps you're an investor and you want to buy companies or invest in businesses. You should probably know what you're looking at when it comes to the income statement. There are so many use cases. I'm a big advocate for financial literacy. So it doesn't matter where you are in life. The best way to build wealth, in my opinion, is through business. And therefore the income statement is going to be super critical to understand.

So I'm going to keep things really simple because I remember in school, our professors were really good at overcomplicating these financial reports and accounting overall. So let's just start with the top. I'm going to break down the income statement just as a refresher. And then I'm going to show you how I like to look at the income statement in blocks and tie that back to a company's strategy. So I know exactly how to improve their performance. So you're going to get into the mind of Steve here.

Let's go ahead and begin. The income statement, starting with the very top line, we have revenue. Revenue is the same thing as sales. It's the top line revenue of a business. And it represents the income that's generated from selling a company's products and services. Pretty easy. I think most people are familiar with revenue.

Underneath that we have cost of goods sold, also known as COGS, abbreviated, or cost of revenue. Essentially these costs are associated with fulfilling the product or service. In other words, delivering the product or service into the hands of customers. Such costs may include material cost, labor costs, direct labor, in other words, to fulfill that product or service. You may have subcontractor cost, and then other direct and indirect costs associated, like I said, with getting that product or service into the hands of customers so you can earn that revenue and record that on your income statement.

All right. So we have revenue, the top line, cost of goods sold next. And then if you take revenue minus cost of goods sold, we end up with gross profit, also known as gross margin. The same thing. Gross just means it's the amount of profit that you earn before overhead. I'm going to get into how I look at gross profit here in just a minute. So let's just keep going.

Underneath gross profit or gross margin, we have OPEX, which is just short for operating expense. Now operating expense includes three main categories, selling and marketing cost, general and administrative expenses, and research and development. Those are the three main buckets under operating expenses. Don't let that confuse you. Just think of operating expenses as overhead. It's the amount of costs that the company incurs in order to run the business, the core operations of the company. Remember these costs are different from cost of goods sold because cost of goods sold represents costs associated with producing the revenue. All right. So don't confuse those two.

Then if we take gross margin minus OPEX, the operating cost, we end up with operating profit. All right. I'm saying operating a lot because here's the key. With operating profit, this represents how much profit or how much margin the business is earning from its core operations. I like to look at operating profit when I'm evaluating a business because I don't want other stuff in there, which I'm going to get into here in just a minute. I want just the core operations and I want to look at that number to determine is the business actually making money from its products and services, right? From the core thing that it does. So we have operating profit.

Then we're not done yet because we have to account for other income and other expense. So just think about these two categories as items that are not associated with day-to-day operations of the business. Other income may include interest income. So if the business has cash and they're earning interest on that cash sitting in a bank, that may hit that account. You may also have a gain on a sale of a piece of equipment. Now, unless you're in the business of selling equipment, then selling a piece of equipment is not core to your company. So for example, when I own my landscape business, we would oftentimes sell our skidsters, our tractors, and then we would upgrade them and buy new ones. So if I was to ever sell a piece of equipment at a value higher than what I paid, offset by depreciation and these other things, essentially I would have a gain on that sale of a piece of equipment. Well, I don't want to record that income under revenue because that gain is not part of my day-to-day business, right? And it'll skew the numbers. So I would record this other income under, well, other income.

Okay. That was a little redundant, but I think you get the point. And then we have other income, then we have other expense. These are expenses that are non-core to the business. Once again, you get the theme here. For example, interest expense, not core to the business unless I'm a bank. And then also I may have a loss on a piece of equipment, et cetera, right? So that's going down in other income, other expense.

Also think about it like this. During COVID, a lot of companies received PPP money in the United States. And when this money was forgiven in a company, they would record that as other income, right? PPP forgiveness or some variation thereof. It would be a huge mistake to record that income as part of revenue because it's not money generated from core operations. And therefore that's where you would record it down in this other section. Doesn’t mean that the other section is not important. Remember, I just want to look at the economics of the business. And therefore I focus mostly on operating profit, which is right above this section.

Okay. I'm going to give you a recap here in just a second, but underneath other income, other expense, we arrive at income before taxes. Now, if you're running QuickBooks or Xero or other programs, maybe it's Oracle, whatever it is, oftentimes in your accounting software, they'll show this as net income.

I don't like that term because I think of net income as after taxes, but here's the thing — in the United States, LLCs, right? Limited liability companies and S corporations, they don't pay taxes. The corporation or the entity itself does not pay taxes. In other words, instead, those profits flow through on a K-1 and they hit the personal income tax return of the owner.

So therefore, if you ever look at a company's financials — an LLC or an S-corp, for example — you're not going to see a line item that says corporate income taxes, like you would with a C-corporation. So when I think of net income, I like to look at an after-tax element and therefore I just call it income before taxes. So just to be clear there and just to get inside my head and how I look at these businesses, there you go.

All right. So that's the breakdown. Let me just go line item by line item without the definitions, just so we're on the same page.

We have revenue.
 Next up we have cost of goods sold or COGS.
 Take revenue minus cost of goods sold — we end up with gross margin or gross profit.
 Take out operating expenses, your overhead — and you arrive at operating profit.
 Take operating profit, subtract out the other stuff — other income, other expense — and you'll arrive at income before taxes.

All right. There are two other terms that you should know. I don't want to confuse you with these, but let me just mention them real quick.

We have EBITDA. So this is a very common term associated with the income statement, which stands for earnings before interest, taxes, depreciation, and amortization. And essentially what you're looking at here is earnings — it’s in the name — earnings before accounting for interest (which is down below in other), taxes (remember companies like LLCs and S-corps, they don't pay taxes), and then depreciation and amortization.

So you may be wondering — what's depreciation and amortization and where does it exist on the income statement?

Depreciation and amortization break down to this. It's really simple. Depreciation is associated with tangible assets — things you can touch, things you can feel, physical things that are there, present in the business. Trucks, trailers, rototillers, tractors, a building, etc. You can touch them, feel them, do whatever you want with them. Massage them. I don't care — if you're a weirdo.

All right. Then there are intangible assets — for example, customer lists, patents, software that's being developed internally, etc. These intangible items — the things you can't touch — are amortized. That's the only difference. Depreciation and amortization: same thing.

Essentially what you're doing is you're trying to record the economic use of these assets. So if I buy a truck for $50,000, I can't just expense the whole thing on my financial statements according to GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). I can't just record all that and take the hit in one year.

Now for tax purposes, we're talking about something else — Section 179, you can write off the entire asset for certain assets — but I'm just talking about financial reporting. The reason why you can't do that is because once again, your financials aren't going to match the economic reality of the business.

If you buy a truck for $50,000, you record it all right now and it's going to last the next five years, you take the hit in this year. But what about the following years? You're not recording the economic benefit and usage of that asset. So you have to depreciate it.

Remember, if it's tangible, you depreciate it. If you can't touch it, you amortize it. That's essentially what you're doing there.

Let me go just a little bit deeper and then I'll tell you where depreciation and amortization sit.

When it comes to that truck — that $50,000 truck — let's say it lasts five years and after five years is worth $0. I just take $50,000 divided by 5. That’s the straight-line approach. There are other approaches as well — I'm not going to get all nerdy on you — but let's keep it simple. Therefore, you would record $50,000 divided by 5 — that's $10,000 a year as depreciation.

The same type of math works with amortization.

Here’s the big thing that I see though, especially when I'm working with small to mid-sized companies: depreciation and amortization is often recorded at the very end of the year at best — or more likely, the following year after the accountant does the taxes and then sends the journal entry over to be recorded on the books.

Here's the problem with that: it's always lagging. So a lot of companies don't anticipate depreciation and amortization and therefore they don't record it in their numbers. But it's a true economic hit to the business. Because if you're not accounting for that truck wearing out, you may think your profits are a lot higher than they actually are.

Or what I see — all the depreciation and amortization are recorded under operating expense.

But here's the deal. If you're running a business — let's say you're running a service business, like a plumbing company — and you have trucks, you have a fleet of trucks. Well, those trucks are being used to generate revenue. Therefore, if you have depreciation on those service trucks, it should be recorded as a cost of that revenue — as a cost of goods sold in other words. But a lot of companies don't break it out that way. Therefore, they look at their numbers and they're not understanding the true economics of their business. And therefore, they're just tricking themselves. They think, “Oh, we're doing so well, look at all our profits.” But really, their companies may not be generating as much as they really think.

So let's talk about the income statement and let's get inside Steve’s scary, dangerous head here. All right. So the way I like to look at the income statement is I break it down into chunks.

The first chunk is at the top of the financial statement. And in this block — so imagine this block — it has revenue, cost of goods sold, and gross profit. That’s the very top of the income statement.

Remember: revenue minus cost of goods sold equals gross profit.

I look at these three line items to tell me one thing — how effective is the company at selling its products and services and making a profit after it delivers those products and services? That’s measured by gross profit. So revenue minus cost of goods sold.

So when I look at gross profit, then that tells me — can the company sell enough volume? Does it have the right price? And is it cost effective in its delivery? That’s the first thing I do.

So here’s a rule of thumb. If a company has a gross profit less than 40%, that could be very problematic. Now it depends on industry — there are so many nuances, so don’t hold me to it — but just generally speaking, I’ll look at a business and I’ll see if it’s generating at least 40% gross profit.

So I just alluded to it — but did you just hear the three levers that I mentioned? You have volume, price, and cost of goods sold. Those are your three levers to influence gross profit.

So if anybody ever asks you, when you’re looking at an income statement, how would you fix gross profit? Those are the three things you should say. You can do more volume — in other words, sell more units, sell more hours, whatever it is you’re selling. Just do more. Or you can change the price. Or you can improve the cost of delivery — which is going to include negotiating better material costs with your vendors, making your labor more efficient (that’s the big one — that’s probably the biggest one), buying out subcontractors better, or managing those other costs in cost of goods sold. That’s it. You can do that, right? Those are the three things.

So you do not have to overly complicate it.

All right. So that’s gross profit.

So when I look at a business, like I said, and I look at the gross profit line item, and let’s just say it’s 20%, I’m like, wow. Okay. Let’s look at the levers.

Do you have enough volume? Are you scaling enough? Are you closing enough deals? What’s your win ratio, right? So I’ll look at all these things to determine if it’s a volume problem.

If it’s not a volume problem, then I move on to price.

Now — pricing is probably the number one lever in the majority of companies out there. And I don’t know if you knew this or not, but if you go to Coltivar.com, we have a really cool calculator under tools — it’s called the levers of profit. Be sure to check it out. It’s free. There’s no opt-in — just go to the page, you can start using the calculator, put in your numbers, and it will tell you exactly the four levers and what the impact is specific to your business and your company’s economics. Super cool. Super easy.

But for most businesses — I could tell you — it’s pricing.

So when I look at pricing, I ask — okay, how sensitive are the customers to price changes? How good is the offer? How clear is the website? What’s the sales process? Is the sales team trained? Are they confident with their pitches?

All these things I’ll look at in order to influence price.

Then if price checks out — then perhaps it’s a cost of delivery problem.

In other words, the company may be paying too much in materials — not too likely. Sometimes that happens, but more times than not, it’s the labor. It’s the efficiency of the labor — that’s one of the biggest costs in a business.

So therefore, I will look at — okay, are they trained? Do they have the skills? Do they have processes, systems? Do they have expectations? Production rates — are those clearly communicated?

What about technology? Do they leverage technology to be more efficient — or is technology making them inefficient? Because it could go both ways. Do they have the right equipment?

In other words, I’m looking at the employees and I’m asking — how can I drive more efficiencies? How can I eliminate friction? And how can I just make them more productive when it comes to fulfilling products or services?

I lightly mentioned this — but subcontractors — if you are doing subcontract work, you can buy out subcontractors more efficiently. But oftentimes people misinterpret this as going with the cheaper subcontractors. I am not a big advocate of that.

Sure — sometimes that may work if they’re doing just generic undifferentiated work. But oftentimes in construction, if you go after the cheapest subcontractor, you could get in a lot of trouble. And it could cost you in a lot more areas — so just be aware of that.

There are other costs like equipment maintenance costs, which are going to hit cost of goods sold. I don’t really get into that a lot because then it confuses people with, okay — is this equipment capitalized? Is it not capitalized? Is it hitting cost of goods sold?

So just be aware that there is a cost associated with that.

Depreciation — that’s a big piece, but that ties back to your capital investments in trucks, trailers, equipment, etc. What does that look like? Are you pursuing capital-intensive work?

We could go on and on and on. I could take you down a rabbit hole — but I’m going to stay out of that.

But just know that those are the three levers of gross profit in that first top section of the income statement.

I’m saying — does the business work, or the economics, right?

Because if those three things are off — in other words, when I look at gross profit, if it’s super low — I know that the model, the business may not be sustainable. Or maybe there’s a huge opportunity to improve the model — but it goes much deeper than just making cost cuts. It involves reinventing the business.

That’s why I’m a big strategy guy — because I believe that strategy, when done right, can really influence the numbers.

So that’s the top section of the income statement. Let’s keep going. Then after I understand whether or not the business works from an operating model perspective — the model, in other words, is working — I will go down to the next section, OpEx and operating profit.

So if I look at operating profit, and if it’s below 10%, okay, that’s just a general rule of thumb. It varies by industry. I have benchmarks on the Coltivar website, if you ever want to go check those out. I’ll provide a link to that as well in the show notes.

But nonetheless, if you look at your operating profit and it’s below 10%, you’re probably below industry average. And therefore, that tells me, number one, your gross profit that we just mentioned is too low. But assuming it’s not too low, then it means your cost of running the business — your overhead costs — are too high. So your labor may not be productive, your expenses are out of control compared to the volume you’re doing, you may just not have the scale, whatever it may be.

But that’s how I can tell whether or not the cost structure of the business is in alignment with the economics of the business. So operating profit is really helpful for me.

I also will just apply a standard tax rate to operating profit to determine net operating profit, especially for LLCs and S-corporations that aren’t technically paying taxes through the business — those pass-through entities. In other words, if they have a bunch of owners, it’s hard to find the exact tax rate, so I’ll just apply a standard tax rate so I can evaluate net operating profit after tax. And that is very important when you’re computing things like return on labor or your return on invested capital.

All right. So I will leave it at that because I wanted to keep things pretty high level. But as a business owner or a manager or an aspiring leader or entrepreneur, I wanted to give you at least a framework for analyzing the income statement so you know how to look at these things in your business and then pull the right levers to drive higher profits.

If you’re looking at your business and you’re wondering — should I grow it, or should I fix it, or should I do both? I have a great tool for you. It’s on the Coltivar website. It’s the four-part Coltivar growth blueprint.

We spent a ton of time putting this together and it’s pretty cool because it has a readiness checklist. It gives you access to calculators, which will tell you exactly at what rate you can grow your business without taking on more debt or equity. That’s a super valuable calculator in itself.

And it will provide you with some other things to avoid — the common traps and KPIs, etc. It’s a great tool. It’s the four-part Coltivar growth blueprint.

If you don’t have it already, I highly recommend it. You can get it at Coltivar.com. I also mentioned other tools in this episode. I will link those down below in the episode show notes.

The last thing I’ll say is that I’d love to hear from you. Whether you DM me on LinkedIn or you leave me a comment through the Spotify podcast. If you’re listening to this on Spotify, there’s a spot down below where you could type in a comment. I read all those and I would love to hear your comments.

What do you think about this episode? Is this helpful? Is this topic something you want me to explore deeper? What can I do to make your life better and to help you be more successful in business? I’m always looking for those types of ideas.

But I’ll leave you with this — and until next time, take care. Cheers.