Bringing in Income

This week’s newsletter will cover the second of the three most important financial statements: the income statement.

1. All about the income

An income statement tells you whether you made more money than you spent. It’s really that simple.

It answers the question: “how much of what we make are we keeping?”. Or “are we profitable?”

An income statement does this by “matching” the sales of a given period with that same period’s expenses. This sounds simple, but it can get complicated. Let’s first look at a simple example of an income statement for a coffee cart business.

Breaking Down the Income Statement

At the start of every income statement is a line for Sales (revenue) in the given period. This is how much money the business made.

Some companies may split revenue by product line as shown with the breakdown for espressos and lattes below.

Once the income statement has accounted for all the money made, it will then report money spent. It will do this in three different sections: cost of goods services sold, operating expenses, and taxes etc.

Each section will subtract the expenses in that section from the revenue (or remaining revenue) to tell us how much money is staying in the business.

Cost of Goods or Services Sold (a.k.a COGS)

The first section of money spent are the Cost of Goods or Services Sold (COGS for short). If you sell a cup of coffee for $5, and it cost you $2 in coffee beans, a cup, and a lid to make that cup of coffee, then your COGS are $2.

The next line after COGS is for gross profit. Gross profit answers the question “how much money do we keep after COGS?”. If you’ve ever heard someone say something like “we’re grossing $x a month”, they are talking about their gross profit.

Below the gross profit is a simple calculation of gross profit divided by sales. This calculation is called the gross margin.

On income statements, margins mean percentages. When someone says something like “our margins are thin”, they mean they aren’t keeping much of what they’re making.

Margins are useful because they answer the question, “for every cup of coffee I sell, how much do I keep?”, or “how many cups of coffee do I need to sell to break even?”.

Operating Expenses

Operating expenses are money spent keeping the lights on (sometimes literally). They are the costs of operating.

If our coffee cart sells twice as much coffee, the operating expenses won’t change. We won’t need to double our spend on insurance. This is why operating expenses are called fixed costs.

COGS on the other hand, will change. If we sell twice as much coffee, we will spend twice as much in COGS. For this reason, COGS are called variable costs.

Below the total operating expenses you can see the operating profit. This is simply the money left over after operating expenses and COGS are subtracted from total sales.

Operating profit is essentially all the money the business keeps before paying for certain uncontrollable costs like taxes, and interest. In fact, many people refer to operating profit as EBITDA (pronounced eh-bih-dah) which stands for earnings before interest, taxes, depreciation, and amortization.

If a balance sheet is like the “net worth” of your business, then EBITDA is like your salary. EBITDA (or “earnings”) is what you make after “controlling what you can control.”

You can control your COGS. You can control your operating expenses. You can’t control things like taxes and interest rates.

Many investors and analysts use EBITDA to assess company performance for this reason. They only want to understand how the company performed with expenses that they can control.

But if you want to know what you’ve made after all expenses, including what you can’t control, then you’ll want net profit.

Net Profit

To know the final answer to our original question “how much of what we make are we keeping”, then you’ll want to get the net profit. Which is simply operating profit minus taxes and some other expenses that we’ll have to save for another day..

Net profit is the final number at the bottom of the income statement, hence why it is also called the bottom line.

2. A direct path to the bottom line

If you are a data professional who wants to impact the business, the income statement will tell you how.

Our coffee cart example was fairly simple, but most income statements are more complicated. They will present plenty of lines of revenue and expenses, each presenting opportunities for improvement.

Ask to see your company’s latest income statement. What can you do to improve your company’s net profit? This is exactly what the leadership at your company is asking.

How can the business increase their margins? Which products are more profitable? Come up with some ideas and use data to explore or test them.

3. The caveat for startups

Many startups have subscription models where they collect payment from customers on a monthly basis. They don’t have ordinary forms of revenue, and therefore don’t have ordinary income statements.

Tien Tzuo writes about this in Salesforce’s The SaaS Startup Founder’s Guide in a chapter titled “The Subscription Economy”:

The book then provides this example of a “subscription economy” income statement.

We’ll dive into what all of this means in another newsletter. For now, just know that if you are working for a SaaS startup, their income statement might look a bit different.