What is an Income Statement?

An income statement (also called a profit & loss – or P&L – statement) is one of the three major financial statements that a startup needs. The others are the balance sheet and the cash flow statement. The three statements are crucial when trying to secure funding from venture capitalists, investors, and lenders. You’ll also need to provide them to your board of directors at your regular meetings.

The income statement shows how much a startup is spending, and how revenue the company is bringing in, over a specific time period. Typically startups in their initial stages have negative income, because the company is investing in building a new product. Even if revenue is zero, startups need to produce P&L statements! Listing the company’s expenses shows where the startup is spending money, and controlling expenses is one of a founder’s most important responsibilities.

The income statement is usually the first financial statement that a VC will look at when evaluating a startup. And experienced founders obsess over their financials, starting with this one, since it shows both revenue and expense performance.

What does an Income Statement include?

As noted above, the income statement has two main sections: revenue and expenses. Revenues include any money the startup has earned, and expenses include all the money a company has spent on its business activities. The difference between those amounts is net income (or loss). An income statement covers a specific span of time, and are typically done monthly, quarterly, or annually.

We recommend producing this every month. And you’ll need an annual report as well for your tax returns.

How to read it - the formulas on the Income Statement

The general formula for the income statement is Total Revenues - Total Expenses = Net Income (or Net Loss). Start at the top of the report, where revenues are reported, and then flow down to take out the expenses and eventually get to the net income or loss. To give a more detailed look at how a company builds an income statement, we can break down the general formula into some steps:

Revenue - Cost of Goods Sold = Gross Profit
Gross Profit - Operating Expenses = Operating Income
Operating Income - Interest Expense = Pre-Tax Income
Pre-tax Income - Income Tax = Net Income (or Net Loss)

Let’s look at some of these terms that can be included on your income statement:

Revenue. This is money your startup earned through selling your products or services.
Cost of Goods Sold (COGS). These are all of the direct costs that your company incurs to produce your products, such as materials and labor. COGS does not include indirect expenses like marketing, sales, distribution, or administrative expenses.
Operating Expenses. These are expenses a business incurs through its normal operations, including things like rent, equipment, inventory costs, marketing, payroll, and research and development.
Selling, General, and Administrative Expenses (SG&A). This is part of your operating expenses, and includes the costs of managing the startup and the expenses of selling and delivering your products.

Interest Expense. Interest expense is the interest that’s payable on any funds a startup has borrowed, including loans, convertible debt, and lines of credit.

Why does a startup need an income statement?

The income statement is a great way for founders, investors, analysts, and other stakeholders to get an overview of the financial health of your startup. While many startups don’t earn a profit, the income statement also provides detailed information about the startup’s expenses and revenue trajectory. It can help founders determine if they’re operating efficiently. Tracking expenses closely lets founders and CEOs see more easily where they should allocate resources, or where the company may need to cut costs. Most importantly, the income statement will help startup management decide when they should raise additional funds – every startup industry has particular metrics that VCs look for that indicate that the company is mature (or hot!) enough to raise the next round of capital. This is where those metrics live.

As noted earlier, you’ll need an income statement when you try to raise funding from venture capital firms or if you’re seeking debt funding. While income statements show a business’s current profits and losses, they’re also used to predict your future profitability, showing the potential for earnings and increased share value. Of course, income statements depend on what type of startup you are. A retail startup with high inventory is not going to have the same expenses as a tech startup with minimal inventory and high fixed asset costs. So investors also compare your income statement to similar startups, to help them evaluate your operational efficiency and how well your startup manages expenses.

Income statement analysis

When analyzing income statements, there are two primary methods: vertical and horizontal analysis.

Horizontal analysis compares changes in the dollar amounts of the various amounts on the income statement over a number of accounting periods. Those changes can pinpoint patterns or trends that provide insights into a company’s performance. For example, if the cost of goods sold (COGS) increases dramatically, it may indicate issues with sourcing raw materials.
Vertical analysis focuses on the relationship between the numbers in a single reporting period. Each item is listed as a percentage of a base figure in the income statement instead of in dollars. For example, to show the relative size of different expenses, the expense line items could be listed as percentages of operating expenses. That way the analyst can review the relative proportions of expenses, to see where costs rose or fell.

Financials effectively communicate your startup’s progress

Financial statements aren’t the most exciting things that founders have to work on. But compiling complete and accurate financial statements on a regular basis is crucial to convince investors that you have a solid business concept. It also sends a strong message to investors, creditors, shareholders, and board members that you’re reliable and serious about your business. For more information about financial statements and startup accounting, please contact us.