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Understanding the Income Statement

If you're like I was before I started the MBA program, you might be completely confused by the income statement. In fact, I actually called it a budget for a long time because I thought that's what it was! Thankfully now I'm a little more up to speed.


If you own or manage a pharmacy it's important to understand financial statements, and honestly if you want to be taken seriously by decision-makers in about any organization you need to learn to 'speak business,' no matter what your official job title is.


Don't worry, I'm going to explain it in plain language. Business is fun - trust me!


Here is some vocabulary to get you started:


Income Statement: Also called a "P and L (or Profit and Loss)" statement. The Income Statement gives you an idea of financial performance over a period of time (typically one month).


It is one of the primary financial statements of any corporation, along with the Balance Sheet, the Statement of Cash Flows, and the Retained Earnings Statement.


Budget: A budget is essentially a forecasted Income Statement. It describes what the organization thinks it will achieve in Revenue and Expenses over a period of time. It is often done once per year and covers the entire fiscal year.


You will commonly see the budget on the Income Statement in a separate column. That allows decision-makers to see if they are on track ("meeting budget").


Balance Sheet: One of the primary financial statements. A Balance Sheet gives you a snapshot at one point in time of the financial health of the entire business.


It is built on the fundamental accounting equation: Assets = Liabilities + Stockholder Equity


The Income Statement versus the Balance Sheet

Thinking of your personal finances, your Income Statement would include how much you earned in salary for the month, how much you spent on bills, and how much is left over (your personal Net Revenue).


Your Balance Sheet would include how much you have in retirement, in your bank account, and in your house in equity (your Assets) as well as how much you owe on your house, your car, etc. (your Liabilities).


Now on to the Income Statement!


Example Income Statement (P and L)

Income statements are divided into revenues and expenses. Revenue and expense reporting is regulated under national (termed GAAP) and international (termed IFRS) accounting standards. All publicly-traded companies must abide by these accounting standards.


Gross Revenue

Gross Revenue is the total of all the money you made before you pay any expenses. It is typically at the top of an income statement (in this example, gross revenue is listed under 'Sales').


Of note, having a lot of gross revenue does not mean the company is profitable. If I have a lemonade stand and I bought $50 worth of lemons (I thought business was going to be good), but sold only $30 (turns out I'm terrible at making lemonade), my gross revenue is still $30, but as you see I lost at least $20 running the business.


Cost of Goods Sold

Cost of Goods Sold, often abbreviated COGS, is fairly self-explanatory from the description. COGS is probably the line item you have the most control over as manager, and it can make or break the profitability of your store, so it deserves some attention.


One important point to note, though, is that COGS is not equal to your purchases for the month. It is equal to the purchases of items you sold for the month, even if you did not buy them that month.


If you bought items that month you didn't sell, that is not part of COGS for the month. In accounting terms what you did was purchase inventory, so the accounting folks would subtract (credit) your Cash account and add (debit) your Inventory account.


We all know, though, in a pharmacy COGS would be impractical/impossible to keep track of, especially with fluctuating drug prices, 1000-count bottles we take 30 out of at a time, etc. That's why we have periodic inventories - to adjust the COGS for the period to reflect actual COGS.


What is typically done is that the income statement each month lists the purchases made for the month, and then after inventory is taken, COGS is calculated from that inventory, and then an adjustment is made to the line on the income statement for COGS to make it equal the calculated COGS for that period.


This method is called (for obvious reasons) a periodic inventory system. It is in contrast to a perpetual inventory system, where every item is tracked. The best example of the perpetual inventory system in the pharmacy is with C2's. In other industries, perpetual inventories are used for high-ticket items where it is reasonable to expect an exact inventory to be tracked, like Hummers or airplanes.


I know it all might sound confusing at first, but this is an extremely important concept to understand because it helps you understand why accounting either adds or subtracts large numbers from you COGS after every inventory (and again this is the largest part of the income statement you have control over).


Check out this post for more explanation on inventory and COGS.


Payroll Expense

Next up is Payroll Expense, which is the second-largest item on the Income Statement you have control over. This one too is mostly self-explanatory, but I do want to bring up some important points:

  • Benefits: Your health insurance, vacation, and subsidized gym membership costs money, too, you know. Businesses have to budget for benefits, and anyone (pharmacist or not) who is in a leadership position knows to add benefits in to the total payroll calculation when considering adding staff.

  • W2 vs 1099 Income: For those of us like me that freelance a lot we fully understand the differences between employee and contractor income, but until I got into medical writing I didn't really know much about it. A "W2 employee" is an employee of the company, whereas a "1099 employee" is a contractor. What's the big deal? The main thing is FICA taxes. It adds up to about 15%, but as a W2 the employer pays half; as a contractor, the contractor pays all 15%.

Most hiring managers/decision makers use a rule of thumb (for estimation purposes) that benefits and FICA taxes cost 25% of annual salary. If your salary is 100k your company is pegging you as a 125k expense.


This is another simple rule of thumb to impress the executives at your company or, if you are a business owner, to be sure you have a full picture of the cost of hiring, so please memorize it - 25%!


Depreciation

We've all used the word depreciation when talking about things losing value (like cars), but in accounting depreciation is used to account for the expense of long-lived items. It doesn't make sense, for example, if a company buys a $1 million piece of equipment that will last 10 years to expense all $1 million in the month that it was purchased. Instead, the item is purchased and on every monthly income statement afterwards, for the period of depreciation, the cost of that purchase is expensed under depreciation.


There are a few ways to calculate depreciation; here are two common methods:

1. Straight-line depreciation. The item is expensed in even amounts over the depreciation period. In this example, the $1 million piece of equipment would be depreciated by $100,000 per year, or $8333 per month.

2. Unit of Activity: If you anticipate a purchase to last a certain number of uses (or hours), rather than a certain time period, this can be a better way to account for depreciation. The best example of this might be a car; when we expense travel, we expense it per mile. This method makes a lot of sense for construction companies that invest in expensive machinery that might be used in varying amounts depending on the project.


Amortization

Amortization is basically depreciation for intangible assets. Probably the easiest example to understand of amortization is a patent. If a drug company invests $1 million in a patent that lasts 10 years, they would expense it at $100,000 per year under amortization, not depreciation, because a patent is an intangible asset.


Miscellaneous Expenses

I've always seen small, miscellaneous expenses on my Income Statements. They might be things like building maintenance or licensing fees. If you are a manager, I wouldn't worry too much about them because they don't strongly influence your profitability and there's nothing you can do about them anyway. If you are an owner, the most important thing to keep in mind is that you remember to actually record these entries as expenses, rather than just paying them out and forgetting about it.


Operating Income

Operating income is the amount of income earned from daily operations; the biggest difference between operating income and net revenue is net revenue is the amount of money after taxes. Another difference between operating income and net revenue is that operating income doesn't include non-operational income streams, like investment revenue.


Net Revenue

Net revenue is how much you've made after all expenses are paid. Pretty easy to understand - this is your profit!


Side Note: Cash versus Accrual Accounting

This doesn't fit in as a line-item on the income statement but is nevertheless relevant and important to understand.


To explain, let's start with an example. Let's say you get a big job on September 26th for $3000. You do the work and get paid on October 15th. Does the $3000 count as income for September, or does it count for October?


It actually depends on your accounting method:


With cash accounting, the income is counted when it is received, so the $3000 would be booked in October. With accrual accounting, the income is counted when it is earned, so the income would be booked in October.


Cash accounting is only used for very small business (like maybe a side gig) and is banned under both GAAP and IFRS accounting standards.


Accrual accounting gives you a more accurate picture of whether or not you are making money because revenues match expenses.


Imagine if you had to pay $2000 in expenses to earn that $3000. Under cash accounting, the $2000 would fall under September (that's when you paid it) but the $3000 would fall under October. Multiply by 50 jobs like that and it would be impossible to even tell if you're making money or not. Now imagine Toyota, for example, using cash accounting with thousands of transactions, and even crossing Fiscal Years. There would be no way to tell how much the company is worth, whether or not to invest, etc. That is the reason cash accounting is illegal under GAAP and IFRS standards.


Final Note

I remember a case from my accounting textbook of accounting standards being lax in Korea for a long time, leading to what investors called the 'Korean Discount.' Basically, because investors could not trust the financial statements for Korean companies, they valued them at much less than equivalent companies overseas.


The point is, accounting matters, and if you even think you might sell your pharmacy one day and your books aren't in order it could cost you a lot of money.


Keywords: accounting, income statement, revenue, expense, Net Revenue, depreciation, amortization, COGS, Cost of Goods Sold, budget, balance sheet