An income statement is one of the most critical tools for understanding a business’s financial health. When considering applications for loans for a small business, many lenders examine this document to assess the applicant’s ability to repay the loan. In addition, analysts, investors, management, and other stakeholders also rely on income statements to make decisions about a business.
What Is an Income Statement?
In a nutshell, an income statement is a financial document showing a company’s operations and financial activities for a certain period. Some people also call it a profit and loss statement or a statement of earnings.
Components of an Income Statement
The main sections of an income statement can include:
- Cost of goods sold
- Gross profit
- Operating expenses
- Operating income
- Non-operating expenses
- Net income
How Lenders Evaluate Income Statements
As mentioned, lenders evaluate income statements to assess the financial viability of a company. The first aspect lenders consider is the overall profitability of the company. They look for consistent positive net income, indicating that the company is generating profits and has the potential to repay the loan.
Additionally, lenders examine the trends in revenue and expenses. They assess whether the company’s revenue is growing steadily or declining, as this reflects its ability to generate cash flows. How deeply they look at the trend can depend on the lender and the magnitude of the loan.
Similarly, lenders analyze the company’s expenses to ensure they are reasonable and well-managed. They also evaluate a business’s net profit margin. A higher net profit margin suggests that the company effectively manages its expenses and generates strong profits, making it a more attractive borrower.
How to Prepare an Income Statement
- Gather financial data: Collect all relevant financial data, including revenue, expenses, gains, and losses, for the specific period you want to analyze.
- Identify revenue sources: Categorize your revenue sources, such as product sales, service fees, or rental income. Ensure you capture all sources accurately.
- Calculate cost of goods sold: Determine the costs directly associated with producing or delivering your products or services.
- Calculate gross profit: Subtract the cost of goods sold from the total revenue to calculate the gross profit. This represents the amount left after accounting for direct production costs.
- Determine operating expenses: Identify and categorize all operating expenses, such as salaries, rent, utilities, marketing, and administrative costs.
- Calculate operating income: Subtract the total operating expenses from the gross profit to arrive at the operating income. This reflects the profitability of your core operations.
- Include non-operating income or expenses: Account for any additional income or expenses that are not directly related to your primary business operations.
- Calculate net income before taxes: Combine the operating income with the non-operating income expenses to calculate the net income before taxes.
- Account for taxes: Deduct the appropriate tax percentage from the net income before taxes to calculate the net income after taxes.
- Finalize the income statement: Summarize all the figures in a clear and organized format to create the final income statement.
Interpreting the Income Statement
Interpreting the income statement involves analyzing key metrics and ratios, including the following:
- Gross profit margin: This ratio indicates the percentage of revenue remaining after deducting the cost of goods sold. A higher gross profit margin generally signifies better profitability.
- Operating margin: The operating margin measures the profitability of a company’s core operations.
- Net profit margin: The net profit margin shows the percentage of revenue that results in net profit after considering all expenses and taxes. It reflects the overall profitability of a business.
- Return on assets (ROA): ROA measures how effectively a company utilizes its assets to generate profit.
- Earnings per share (EPS): EPS indicates the portion of a company’s profit allocated to each outstanding share of common stock.
Common Challenges in Preparing Income Statements for Lenders for Small Businesses
Accurately Categorizing Expenses
Small businesses can have limited accounting resources and may struggle to allocate expenses correctly. This may lead to an inaccurate representation of the company’s financial performance, which can negatively impact the loan application process.
Completeness and Accuracy of Financial Data
Incomplete financial data can distort the company’s financial health and mislead lenders. That’s why small businesses should maintain meticulous financial records and regularly reconcile their accounts to ensure the accuracy of their income statements.
Projecting Future Revenues and Expenses
In some cases, lenders may require revenue projections to assess the company’s repayment capacity. Here, some small businesses may find it challenging to provide realistic and well-supported projections to instill confidence in lenders.
Other Key Financial Statements
While the income statement provides valuable insights into a company’s financial performance, lenders may also look at balance sheets, cash flow statements, and inventory reports.
The balance sheet gives readers an idea of a company’s financial position at a specific point and can complement the income statement. Meanwhile, the cash flow statement is a read of the inflow and outflow of cash within a specific period.
Some lenders may need to carefully assess a business’s projected cash flow before approving a loan. Take, for example, Merchant Cash Advances (MCAs), which are useful for small and medium-sized businesses that need access to cash but can’t satisfy the metrics of conventional lenders. A healthy cash flow document can help a small business secure MCA loans. Check out our guide on how to do a cash flow statement to learn more.
Some income statements also carry the ending inventory balance. However, for a more comprehensive list of a business’s in-stock quantities and types of items, a banker may ask for a copy of a business’s current inventory report to analyze their sales and inventory management practices.
Learning To Interpret Financial Statements
Here are some tips that may help you learn how to read financial statements:
- Learn financial statement terms.
- Benchmark the financial statements against industry standards or competitors to gain insights into relative performance.
- Look for trends and patterns in the financial statements over multiple periods.
- If you find financial statements overwhelming or require in-depth analysis, consider consulting with a professional.
Mastering the Income Statement for Financial Success
Lenders, analysts, or investors will need to see more than your executive summary when judging your business’s financial health. And an income statement is one of the most important documents for businesses. By harnessing its power, companies and individuals can make educated decisions, identify areas for progress, and drive toward their financial goals.