Over the past several weeks, we have been ⛵️ sailing the seas of accounting history and have touched on how it presently impacts insurance agencies. We’ve seen how bookkeeping has evolved, discussed groundbreaking methods developed in the Middle Ages, and we have laid out some of the basics of a Chart of Accounts. But, what’s next? How is the information pulled together into something meaningful? Financial statements. This week, we will highlight the Income Statement (or Profit & Loss Statement)…Its structure, how best to glean insights from its numbers, and, of course, its history.
What is an Income Statement?
The Income Statement (also commonly referred to as a P&L or Profit & Loss Statement), is a financial statement that provides a summary of a company’s revenues and expenses over a specific period of time–usually a month, quarter, or year.
Accounts are listed in a particular order–revenue then expenses–and net subtotals are usually included in each section. A company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) are included, as well as the final net profit (or loss).
Interpreting and Managing an Income Statement.
In disciplines such as accounting and finance (and insurance!), a superficial grasp might suffice for most day-to-day operations. However, delving deeper can yield instrumental insights, especially concerning the P&L. Many adopt a simplified perspective: if revenues surpass expenses, all is well. But there is more, and starting with an outlook on how a P&L could be ideally structured might be a good way to demonstrate.
We like to think about the P&L having three metrics that correspond to business model decisions:
- Product/Service Profitability – Gross Margin:
At its core, the P&L often starts with the profitability of your product or service, commonly termed as “gross margin.” This metric calculates the difference between revenue and the Costs of Goods Sold (COGS). Take, for instance, a t-shirt that costs $6 to produce but sells for $20, leading to a commendable 70% gross margin. Such a perspective can trigger essential questions about pricing strategy and cost-efficiency. In service-oriented industries, like insurance, the manufacturing aspect isn’t present, making the concept of ‘Cost of Revenue’ more relevant. Beyond just commission or report fees, this category can encompass direct sales costs, including marketing & advertising, licensing, lead generation, sales tools, and even travel & entertainment, granting a clearer perspective on true costs of generating revenue.
- Operational Profitability – Operating Margin:
Next in line is the operational profitability, epitomized by the term EBITDA, which showcases the pure profitability of business operations (a little more on EBITDA below and a lot more to come in the future!). It can be thought of as taking the gross profit and subtracting out overhead, admin expenses, and/or any other general, non-direct sales costs of the business operations. The operating margin takes both the product/service and business overhead components in its calculations, but structuring and thinking about the P&L with the “overhead” summary broken out allows agencies to effectively monitor and manage their expenses for strategic decision making purposes. For instance, when times are tough and expense cuts are necessary, it may be highly advantageous for an agency principal / leader to know exactly what non-revenue generating expense items can be the first to be cut. And this kind of instinct can be best fostered when the monthly Income Statement is produced with the items broken out and you start to see the numbers in your head when you’re falling asleep at night!
- Financing and Capitalization Margin:
Lastly, after the Operating Income or EBITDA total on the P&L, the only distance left to Net Income are interest expense, tax expense, depreciation, and amortization. These all represent the financing and capitalization decisions crucial for the business. Although EBITDA is beneficial in some contexts, excluding these costs which are things like interest from acquired debts (loans to buy the business or credit facilities to finance working capital) or the depreciation of significant assets (like a building you host your office in) may not be appropriate. It’s essential to interpret these costs in the context of the strategic choices an agency makes. You may not want to relentlessly pursue EBITDA if your investment horizon is a long-term hold and your desired returns are in maximizing distributions. Alternatively, you may care about “EBITDA-only” if you’re charging up to exit your agency in the next 3-5 years. All just depends on what your goals are and how you want/need to finance your business or invest in assets accordingly.
In essence, a deeper dive into these components of the Income Statement provides not just a more informed perspective but also actionable insights for businesses aiming for longevity and growth.
History of the Income Statement
The concept of tracking income and expenses has been a part of accounting for centuries. In ancient times, businesses and individuals maintained a simple record of their financial transactions; however, these early forms of accounting were not as standardized or structured as modern financial statements.
With the introduction of the Venetian method of accounting, a more structured approach to recording financial transactions laid the groundwork for financial statements, like the P&L and Balance Sheet (we will chat about the Balance Sheet in one of our next posts).
During the 19th century, as businesses and commerce expanded, there was growing need for more comprehensive financial reporting. Companies began to prepare Income Statements, which included revenue and expenses, to provide a clearer picture of their financial performance.
The Industrial Revolution in the 18th and 19th centuries led to the development of large corporations and increased the complexity of financial transactions. For the first time, revenue and expenses were sub categorized by classes/locations. This period also saw the introduction of various regulatory and accounting standards, such as the British Companies Act of 1862, which required companies to prepare Profit & Loss statements.
In the following century, there were increased efforts to standardize accounting and financial reporting. Organizations like the American Institute of Accountants (now the American Institute of Certified Public Accountants, or AICPA) were established to develop accounting standards and principles. The Income Statement became a standard component of financial reporting during this time.
Over time, accounting standards have evolved and become more comprehensive. In the United States, the Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS) have played significant roles in setting standards for Income Statement preparation. These standards provide guidance on how revenue and expenses should be recognized and reported.
To see the prior articles: