How do I read an income statement?

01What the statement covers, and on what basis#

Every income statement states its period: a month, a quarter, a year to date. A balance sheet is a photograph on one day; an income statement is a film of a period, and the two are not comparable unless you know which film you are watching. A figure without its period is not a figure.

It also states its basis. US GAAP requires accrual basis: revenue is recognized when it is earned, under ASC 606, and expenses when they are incurred, whether or not cash has moved. If December’s hosting bill arrives on January 5, it is still a December expense, and the close books it there: debit Hosting $8,000; credit Accrued expenses $8,000, dated December 31. When the bill is paid, the accrual is cleared and the expense does not move again.

Many small companies file taxes on cash basis, and QuickBooks Online and Xero will each show you either view with one toggle. That makes it easy to read the wrong one. The statements an investor, a lender or a CPA review relies on are accrual.

02Line by line, with a worked month#

Take an illustrative month at a seed-stage SaaS company, in round numbers. Losses are shown in parentheses, the way financial statements show them:

Each subtotal answers a different question. Gross profit says whether the product itself makes money each time it is sold. Operating income says whether the company makes money after it pays the people building and selling the product. Net income adds what sits outside the business’s operations: interest earned, interest paid, gains and losses on things you do not sell for a living, and income taxes.

• Revenue: $100,000.
• Cost of revenue: $25,000 (hosting, payment fees, support).
• Gross profit: $75,000, a 75% gross margin.
• Operating expenses: $110,000 (research and development $60,000, sales and marketing $30,000, general and administrative $20,000).
• Operating loss: ($35,000).
• Other income: $2,000 of interest on the cash in the bank.
• Net loss: ($33,000).

03Revenue and cost of revenue#

Revenue is what you earned in the period, not what you billed or collected. A customer who pays $12,000 for an annual plan in March adds $1,000 to March revenue and $11,000 to deferred revenue on the balance sheet. A refund reduces revenue in the month it happens. Sales tax you collect is not revenue at all; it is a liability to the state.

Revenue is shown gross. Stripe’s processing fee is an expense, not a reduction of the price, so $10,000 of charges is $10,000 of revenue even if the payout was $9,680. Netting fees out of revenue understates both lines, and it is one of the first things a reviewer unwinds.

Cost of revenue is what it costs to deliver what you sold: hosting, third-party services embedded in the product, payment processing, customer support and onboarding. It is the line that sets gross margin, which is why classification matters. Moving support staff from cost of revenue into operating expenses raises gross margin without changing anything about the business, and an investor comparing your margin to other companies will ask where support lives.

04Operating expenses#

Below gross profit sit the costs of running the company, usually grouped by function: research and development, sales and marketing, and general and administrative. Payroll is the largest line in almost every startup, so it should be split by function too, not left in one account called Salaries. The department each person works in is what sends their wages to R&D or to sales.

Some expenses involve no cash at all. Depreciation spreads the cost of equipment over its useful life. Stock-based compensation, under ASC 718, expenses the grant-date fair value of options over their vesting period. Both reduce net income; neither reduces cash. They are real expenses for GAAP, and an income statement without them is understated.

Other expenses are prepaid. An annual insurance policy paid in January is an asset that is expensed one month at a time, $1,000 a month on a $12,000 policy, not $12,000 in January and nothing after.

05Below the operating line#

Interest income on your cash, interest expense on a venture loan, foreign exchange gains and losses, and a change in the fair value of a SAFE carried at fair value all sit below operating income. They are real, but they are not the business, and keeping them below the line is what lets operating income be compared month to month.

Income tax comes last. Most early-stage companies have a net loss and little or no federal income tax, but state minimum taxes and franchise taxes still arrive, and a profitable month can still carry a tax provision. A CPA review will ask how it was estimated.

06What founders misread#

Most misreadings come from forgetting that the statement is accrual basis and that it covers a period. A list of the usual ones:

• Reading net income as cash. It is not, and the gap is often largest in the months that matter most.
• Reading revenue as billings. An annual invoice is a balance sheet event first, and revenue over the year.
• Comparing a month to itself. Put the prior month and the same month last year beside it.
• Ignoring non-cash expenses. Stock-based compensation is small on the bank statement and large on the P&L.
• Trusting a cash-basis toggle. A cash-basis P&L can look profitable while bills pile up unpaid.
• Treating gross margin as fixed. It moves with every reclassification, so the policy behind it matters more than the number.

07How it ties to the other statements#

Net income does not stay on the income statement. At the end of each period it closes into equity, into retained earnings, or for most startups the accumulated deficit, on the balance sheet. And it is the first line of the cash flow statement under the indirect method, where non-cash expenses are added back and changes in working capital explain the rest of the gap to cash.

That is the test of a set of statements: the net loss of ($33,000) appears in three places and is the same number in all three. If it is not, something was posted after one of them was run, or the period was not locked. The close is what makes the three agree.