What is an income statement?
An income statement is a financial statement that reports the income and expense, gain and loss activity, and net income or net loss for an entity or person in a given time frame. Common time frames include monthly, quarterly, and yearly. Income statements are presented in various formats, comparing current month or year amounts compared to budgeted amounts or prior year amounts.
Trended Income Statement
A trended income statement shows income, expense, and net profit (loss) for twelve months, with the current month as the 12th month, and the prior 11 months in each column to the left. This is known as a Trailing Twelve Month statement, or TTM for short.
How to Use a Personal Income Statement
If a bookkeeper produced your personal income statement in the format of the TTM statement, you'd analyze it by looking for trends in three areas: revenue, expense, net income, and gross margin.
Is your income increasing over time? If you have multiple income streams, make sure you include each category of revenue on your income statement.
Categories are like departments or business lines. For rental property, you will have “rental income” at the top. If you have affiliate income from your website, show a line item with “Affiliate income” in your revenue section. Interest income from high yield bank accounts will show up in a line called “Interest Income”.
If you are a business owner, you may choose to separate out your business revenue and expense to a separate P&L, and bring into your personal income statement the profit or loss as a revenue line item called “Business Income”.
Investment gains or losses are typically accounted for as “gains or losses” in a section under expenses, before the net income line. They will be used to adjust the balance sheet account to the correct balance. This isn't always done every month, but it can be. This type of entry is known as “Mark-to-Market”. In securities trading, mark to market involves recording the price or value of a securities or brokerage account to reflect the current market value rather than book value.
When examining the expense section of the income statement, these questions can help you analyze your results:
- Are your expenses within the expected range?
- What is your average spend per month?
- If you quit your day job tomorrow, what amount would you need each year to live, based on your average monthly spend?
- Are there areas you can reduce your spend? Are there totals per category that surprised you?
- What can you improve over the next 12 months?
What I love about the TTM expense trend is that you don't need to wait until a New Year to make a change. It works for any month of the year.
The net income line is also known as the Profit/Loss line. If its negative, you spend more than you made for the period. If its positive, you made a profit. Are you consistently profitable every month? Is your profit or loss more or less than what you budgeted?
As you're looking for ways to increase your net income, remember that you have two primary ways to make that happen: increase revenue or decrease expense. On FIRE blogs and discussions I see most of the focus on reducing expense. Here's the problem with that: you can only reduce expense so much – it can only go down to zero. Revenue, however, can increase infinitely.
Gross Profit Margin
Gross profit margin, or gross margin is simply net income divided by revenue. A manufacturing company would calculate it as Revenue – Cost of Goods Sold / Revenue x 100. But we aren't a manufacturing company and we have no “Cost of Goods Sold”. You could also call it gross profit percentage. I refer to it as “gross margin”.
Gross margin is a Key Performance Indicator (KPI) that can be tracked over time to indicate how well you are performing financially. Your goal is to maximize your gross margin. Think of it this way – all of your personal efforts related to your day job or running your business product a certain amount of revenue. Of that revenue, how much are you paying yourself? You pay yourself when you KEEP or SAVE part of what you earn.
If you are making progress toward financial freedom by maximizing revenue and minimizing expenses, you should see your gross margin increase over time. A solid goal is 20%, but more aggressive models will budget for 30% or higher.
Trailing Twelve Months (TTM) Trend
Year end income statements are great – but sometimes they don't tell the full story. Year-end data will not provide an accurate picture of the company’s or person's current financial health. What if the last 6 months were trending downward, and the net income was a result of good performance in the first 6 months of the year?
Trends are important – they tell us where things could be headed in the future. You can easily grab 12 months and create a line chart with a linear trend-line to quickly see if performance is increasing or decreasing over time. Here's an example of trending net income:
The one-time December $10k bonus complicates the trend above. A way to adjust for that would be to normalize the statement. This is done by removing the bonus before generating the chart, along with the one-time Christmas purchases that were made with the bonus. It will provide a truer picture of trend, but clouds the actual results based on what occurred. For that reason, I recommend leaving it in for personal finance purposes.
In a business income statement, however, normalizing for operations by removing one-time events can be helpful for creating more accurate trends to project future results.
Despite the anomaly in December, the yellow trend-line provides an indicator that shows net income trending upwards over time. This is the type of trend that indicates our finances are headed in the right direction.
Trended income statements have several indicators that can help the statement user judge performance of a company or person's financial performance. This type of statement identifies trends in revenue growth, expenses, net income, and gross margin. Information provided in a TTM trended income statement can help business owners and individuals make better decisions about their operations and personal finance decisions.
Want to learn more? Read my article on how to create a personal financial statement using the accrual method.