A merchandising business also has a Cost of Goods Sold section.
If you are preparing the income statement manually, you will pick up the amounts from the Income Statement columns of the worksheet (Chapter 6). A computerized accounting system lets you skip this step; you just choose the income statement option from the Reports menu.
Revenue
The Revenue section shows the amount earned from selling the business’s services. It is sometimes called the Sales section.
Expenses
The Expenses section of your income statement provides a summary of all the costs you incurred to earn revenue in this specifi c accounting period. Examples include administrative fees, salaries, advertising, utilities, and asset depreciation.
Net Income or Net Loss
This section shows the bottom line: whether or not the business made a profi t during the accounting period. If revenue exceeds expenses, you have a net in- come. If expenses are higher than revenue, you have a net loss. (It may be inter- esting to know that approximately 25 percent of sole proprietorships report a net loss; many of these businesses are in their fi rst year of operation.) In the rare event that revenue and expenses are equal, the business is said to “break even.”
Figure 7-1 shows the income statement for Andrea’s Artistic Visions. The revenue and expenses amounts are taken directly from the worksheet in Chapter 6 (Figure 6-3).
Note that the income statement has a three-line heading: • Name of company.
• Name of fi nancial statement. • Period of time reported.
7.1.2 Gaining Insight from an Income Statement
The income statement is a useful tool for business owners. The following guidelines are worth considering:
• Most business owners prefer not to show all their operating detail to outsiders. Remember, the more information you give to outsiders, Small Business
Accounting in Action
Summarize your fi nancial results for people both inside and outside the company.
the more they know about how your company operates and the easier it is for them to come up with strategies to compete with your busi- ness. Therefore, you should consider summarizing the Expenses sec- tion in income statements that are distributed externally. For external statements, many businesses group all advertising and promotions ex- penses into one line item and all administrative expenses into another line item.
• If you notice a downward sales trend, it may be a sign that a com- petitor is successfully drawing customers away from your business.
It may also indicate that customers are dissatisfi ed with some aspect of the products or services you supply. Whatever the reason, preparing a monthly income statement gives you the ammunition you need to quickly fi nd and fi x a problem, thereby minimizing any negative hit to your yearly profi ts.
• Business owners watch their expenses trends closely to be sure they don’t creep upwards and lower the company’s bottom lines. Any cost-cutting you can do on the expenses side is guaranteed to increase your bottom-line profi t.
Figure 7-1
The income statement summarizes the company’s fi nancial performance for a specifi c period of time.
Andrea's Artistic Visions Income Statement
For the Month Ended January 31, 200X
Revenue Art Fees $ 8,000 Expenses Advertising 500 Bad Debt 250 Insurance 100 Supplies--Art 900 Supplies--Office 850 Depreciation--Equipment 125 Depreciation--Car 225 $ Total Expenses 2,950 Net Income $ 5,050
141
7.1.3 Analyzing the Income Statement
You may fi nd it helpful to see how your income statement results compare to industry trends for similar businesses with similar revenue; this process is called benchmarking. By comparing results, you can fi nd out if your revenue and expenses are reasonable for the type of business you operate, and you can identify areas with room to improve your profi tability. You also may spot some red fl ags for line items upon which you spend much more than the national average.
To fi nd industry trends for a business like yours with similar revenue, visit www.bizstats.com. To use the statistics tool on this Web site, select the industry that best matches the one your business operates in, such as Archi- tectural Services or Home Health Care Services. (The site also includes merchandising and manufacturing industries.) Then enter your total Benchmarking:
The process of comparing your results to industry trends for similar businesses.
Benchmarking:
The process of comparing your results to industry trends for similar businesses.
By staying up to date with fi nancial statements, the new owner of a dance studio keeps her inves- tors in the loop.
Ingrid had danced in ballet companies all over the world. Later, she taught at half a dozen dance studios in the Boston area, which perfectly suited Ingrid during the years in which her two daughters were young. However, having to follow the scheduling and administrative whims of her employers— the studio owners—began to wear thin, and by 2006 Ingrid was ready for a change.
After learning that a nearby studio owner was moving out of state, Ingrid formed a plan. She, along with a friend and a cousin who were looking for an investment opportunity, put together the money to buy the studio. Though the studio was well known, business had suffered in the past year after the owner had dropped many of the traditional ballet classes, replacing them with dance classes such as hip-hop.
Ingrid put together a comprehensive business plan, incorporating information from the owner’s recent fi nancial statements, which clearly indicated a loss of revenue, likely due to the number of other studios that already specialized in the new dance styles. “It can be a good idea to try new things, but not at the expense of the business,” says Ingrid. To the great relief of her investors, Ingrid reinstated the more formal ballet classes, and enrollment gradually started to recover, all of which was reported in the business’s monthly and quarterly income statements. One change that she did make, with little added expense, is to add a ballet fi tness class for women. Ingrid plans to keep the class open for six months to see if the idea catches on and becomes profi table.
Tips from the Professional
• Stick with what you know.
• Take the time to prepare a business plan.
• Keep investors up to date with the business’s fi nances.
CAREER CONNECTION
business revenue, click Compute, and review the resulting average profi t- ability and expenses percentages for similar small businesses.
With a completed income statement, you can do a number of quick ratio
tests to measure your return on your business. Return means the percentage
you make on a base amount. Three common tests include the following: • Return on sales.
• Return on assets. • Return on equity.
To compute return on assets and return on equity, you need the balance sheet. These ratios are covered in Section 7.2. The return on sales (ROS)
ratio tells you how effi ciently your company runs its operations. Using the information on your income statement, you can measure how much profi t your company produced per dollar of sales.
You calculate ROS by dividing net income before income taxes by sales: Net income before taxes Sales Return on sales
If your business isn’t a C corporation, you don’t have to consider income taxes because only C corporations pay income taxes. (Business income taxes are covered in Appendix B.)
Andrea’s Artistic Visions had sales of $8,000 and net income of $5,050. The return on sales is calculated as shown here:
$5,050 $8,000 63.1%
As you can see, the company made 63.1 cents profi t on each dollar of sales. This is an exceptionally high return on sales, especially for a business in its fi rst month of operation. An established and profi table business of this type would typically have a return on sales around 30 percent.
To determine whether your own return on sales calls for celebration, you need to fi nd the ROS ratios for similar businesses. Check with your local Chamber of Commerce to see whether it has fi gures for local busi- nesses, or order a report for your industry online at www.bizminer.com. (There is a fee for this online service.)
7.1.4 Using the Income Statement Data
The income statement you produce for external use—for fi nancial institutions and investors—may be very different from the one you produce for in-house use by your managers. Most business owners prefer to provide the minimum amount of detail necessary to satisfy external users of their fi nancial statements, such as summaries of expenses instead of line-by-line expenses details.
Internally, the contents of the income statement are a different story. With more detail, your managers are better able to make accurate business decisions. Most businesses develop detailed reports based on the data Quick ratio:
Another name for acid test ratio.
Return:
The percentage a business makes on a base amount.
Quick ratio:
Another name for acid test ratio.
Return:
The percentage a business makes on a base amount.
Return on sales (ROS):
Ratio that indicates how effi ciently a company runs its operations.
Return on sales (ROS):
Ratio that indicates how effi ciently a company runs its operations. Small Business Accounting in Action Analyze an income statement.
143
collected to develop the income statement. Items are commonly pulled out of income statements and broken down into more detail.
For example, many businesses design a report that looks at month-to-month trends in revenue, expenses, and income. Companies also design reports that compare actual spending to the budget. If you were reviewing this report, you’d fl ag any line item that’s considerably higher or lower than expected and then research it to fi nd a reason for the difference.
Retailer Return on Sales
Claire’s Stores, Inc., is a leading specialty retailer of value-priced jewelry and accessories for girls and young women. The company, which operates two different types of store concepts, Claire’s (North America and Europe) and Icing, was sold to another company in May 2007. The company has sought to expand internationally, with more than 859 stores in Europe alone. The company’s European stores are typically smaller than North American stores, but account for more than twice the sales per square foot of their North American counterparts. As a result, the company’s plans for expansion in Europe are more aggressive than in North America.
According to the fi nancial information on the company’s Web site (http://www.clairestores.com/phoenix.zhtml?c=68915&p=irol-company), the fi scal year 2007 return on sales (pre-tax) was 18%, down 1% from fi scal year 2006.
IN THE REAL WORLD
In one month your business had the following trans- action totals:
Sales $12,500 Expenses 9,300 Withdrawals 1,500
a. What is the net income or net loss for the month? b. What is the return on sales for the month? SELF-CHECK
1. In what order are the fi nancial statements prepared?
2. Explain why a company would prepare more than one version of its income statement.
3. What is the formula for determining the bottom line?
4. What is benchmarking? What are the benefi ts of benchmarking?
Apply Your Knowledge
After completing the income statement, you prepare a statement of owner’s equity and a balance sheet. Small-business computerized accounting systems often combine both fi nancial statements into one report titled “Balance Sheet.”
7.2.1 The Statement of Owner’s Equity
The statement of owner’s equity shows the changes to equity in an ac- counting period. It includes investments, withdrawals, and the results of business operations.