Knowing how to read an income statement isn’t just a nice-to-have — it’s essential. If you’re running a business, managing a team, or involved in decision-making, this is a skill you can’t afford to ignore.
Think about it: your accountant hands you the income statement at the end of the month. Do you just glance at the numbers and move on? Or do you actually understand what they’re telling you about your business?
Or maybe you’re in a boardroom, and the financials are up for review. Can you look at that income statement and clearly see how the business is performing — where the money’s going, what’s driving profits, or where things might be going off track?
If you’re not fully confident, you’re not alone. But that’s exactly why it’s worth learning. You don’t have to be an accountant — you just need to understand what the numbers mean so you can make smarter, more informed decisions.
Most businesses put together financial statements regularly, not just to tick a box, but to really understand how the business is performing. These reports are more than just paperwork; they offer real insight into how the business is running and where it’s heading.
When you know how to read them — especially the income statement — you start to see the bigger picture: how money flows in and out, what’s working, and what might need your attention. That kind of clarity helps you plan better, act faster, and lead more confidently.
What Is an Income Statement?
An income statement — sometimes called a profit and loss statement or P&L — is the financial statement that summarizes how a business has performed over a specific period. It shows you whether the business is making money and how much it has earned during that period. In simple terms, it gives you a clear picture of the business’s performance.
The income statement follows a simple structure — it starts with total revenue and works its way down to net income (the profit or loss). Each line tells part of the story of how the business earned money, where it spent money, and what was left at the end.
Here’s a breakdown of the key components you’ll typically see:
Key Parts of an Income Statement
Revenue
This section shows the total amount of money a business earns from selling its goods or services. For example, if your main business is selling cakes, the total income made from those sales would be recorded here as your revenue.
Cost of Goods Sold (COGS)
This includes all the direct costs involved in producing the goods or services the business sells. For example, if a business makes and sells cakes, COGS would cover the cost of ingredients like flour and sugar used to make those cakes.
Gross Profit
Gross profit simply shows what’s left after you take out the direct costs of producing what you sell. It tells you how much you actually made from your sales — before things like rent, salaries, or marketing come into the picture.
Formula:
Gross Profit = Revenue – Cost of Goods Sold
Let’s say you made £10,000 selling cakes, but it cost you £2,000 in ingredients and packaging. That means your gross profit is £8,000. That’s your real “earning power” before the overheads show up.
Operating Expenses
These are the regular, day-to-day costs of keeping your business running — rent, staff salaries, internet, utilities, marketing, admin tools, etc. They’re not part of making your product directly, but you still can’t run without them. For example: If you run a bakery, your flour is part of your cost of goods sold — but your cashier’s salary or shop rent? That goes under operating expenses.
Operating Income (a.k.a EBIT)
This tells you how much profit you made from the actual business operations — before you deal with loans, taxes, or any extra income you made on the side.Formula:
Operating Income = Gross Profit – Operating Expenses
In plain terms, this is the number that shows how well your business is running on its own.
Other Income and Expenses
This section includes anything that isn’t part of your regular day-to-day operations. Think of it as the “extra stuff” — things that still impact your profit, but aren’t tied to your main business activities. For example, maybe your cake company sells an old oven and makes £1,000 profit on it — that goes under other income. On the flip side, if you had to pay a one-time legal fee or took a loss selling outdated equipment, those would show up as other expenses. These items don’t reflect how your core business is performing, but they still affect your bottom line, so it’s worth paying attention.
Net Income (or Net Profit)
Now we’re at the bottom line — the number everyone wants to see. Net income shows what’s truly left after everything is accounted for: expenses, interest, taxes, and so on.
Formula:
Net Income = Operating Income ± Other Items – Taxes
If this number is positive, your business made a profit. If it’s negative, it took a loss. Simple as that.
Putting It All Together: A Simple Income Statement Example
To make this real, let’s look at a basic sample of what an income statement might look like for a small cake business. (Yes, let’s stick with our cake shop example — it’s relatable and easy to follow.)
| Income Statement (for the month of March), Amount (£) | |
| Revenue | 2,000,000 |
| Cost of Goods Sold (COGS) | 800,000 |
| Gross Profit | 1,200,000 |
| Operating Expenses | |
| – Rent | 100,000 |
| – Staff salaries | 150,000 |
| – Utilities | 50,000 |
| Total Operating Expenses | 300,000 |
| Operating Income (EBIT) | 900,000 |
| Other Income (interest earned) | 10,000 |
| Other Expenses (equipment maintenance) | 20,000 |
| Net Income Before Tax | 890,000 |
| Taxes | 60,000 |
| Net Income | 830,000 |
How to Read This Income Statement (Line by Line)
Here’s how you’d break it down as a manager or business owner:
Revenue: The shop made £2,000,000 from cake sales this month.
COGS: It spent £800,000 on ingredients and packaging.
Gross Profit: After covering the direct costs, it has £1,200,000 to cover other business needs.
Operating Expenses: Rent, salaries, utilities, and marketing added up to £300,000.
Operating Income: After paying those operating expenses, the shop is left with £900,000 from its core operations.
Other Income/Expenses: It earned some interest (£10,000) and spent £20,000 fixing an oven.
Net Income Before Tax: That gives us £890,000 before taxes.
Taxes: The tax bill was £60,000.
Net Income tells you your final profit after covering all expenses – in this case, that’s £830,000. That’s the real bottom line.
Once you learn how to read it, understanding the numbers becomes second nature. Instead of seeing random figures, you’ll start spotting patterns. You’ll get a clearer picture of whether your business is truly performing well — or just appearing busy. And when expenses creep up or sales look strong but profits stay weak, you’ll notice it right away.
And the best part? You won’t have to wait for someone else to explain what your numbers mean.
Key Income Statement Ratios Every Business Owner Should Know
Reading the income statement is just step one. Once you’re comfortable with the basic layout, the next level is learning to pull out insights — the kind that help you make decisions, spot issues early, and measure your performance with clarity.
That’s where these simple but powerful ratios come in.
- Gross Profit Margin
Formula:
(Gross Profit ÷ Revenue) × 100
This shows how much money you keep from every £1 of sales after covering the direct costs (COGS). It helps you understand your pricing and cost control.
Why it matters: If your gross margin is shrinking, either your costs are rising or your prices need a second look. It’s one of the quickest ways to spot profitability leaks.
Example:
£1,200,000 Gross Profit ÷ £2,000,000 Revenue = 60%
That means for every £1 earned, £0.60 is left after covering product costs.
- Operating Profit Margin
Formula:
(Operating Income ÷ Revenue) × 100
This tells you how much profit you’re making from your core business activities after paying operating expenses — but before taxes and interest.
Why it matters: A low operating margin can mean your business is running inefficiently, even if your sales look good on the surface.
- Net Profit Margin
Formula:
(Net Income ÷ Revenue) × 100. This is the bottom-line ratio — what percentage of revenue actually becomes profit after all costs, taxes, and other items.
Why it matters: It tells you how “healthy” the business really is. You can be earning millions in sales and still be unprofitable. This ratio keeps it real.
- Interest Coverage Ratio
Formula:
Operating Income ÷ Interest Expense
If your business has loans or debt, this ratio tells you how easily you can meet your interest obligations. It’s often used by lenders to assess risk.
Why it matters: The higher the ratio, the safer your business looks to lenders, and the less financial pressure you’re under.
- Earnings Before Tax Margin (EBT Margin)
Formula:
(Earnings Before Tax ÷ Revenue) × 100
This helps you understand profitability before taxes are applied, especially useful if you want to evaluate the business without local tax influences.
Why it matters: Gives you a cleaner view of how operational and financial decisions (not tax laws) affect your bottom line.
Vertical Analysis: Seeing the Numbers in Context
Looking at the numbers in your income statement is good — but looking at them in relation to one another? That’s even better. That’s what vertical analysis helps you do.
Instead of just seeing £2,000,000 here or £800,000 there, vertical analysis shows you what percentage each line item is relative to your total revenue. This helps you compare different periods — or even compare your business to others — regardless of size.
Why It’s Useful
- You see where the money’s really going. Rather than just looking at costs as standalone numbers, you understand how significant they are in the bigger picture. Let’s say your revenue doubled, but your profit margin stayed flat — vertical analysis makes that clear.
- You can benchmark your business. Want to know if your marketing costs are too high or your profit margins are healthy? Compare your vertical breakdown with industry averages.
Now, if you’re using vertical analysis, you’re breaking down each expense line as a percentage of revenue, all within the same period. It helps you see how much of every dollar earned goes to various parts of the business. It’s like turning the numbers into a story. You see which areas are eating up revenue and where you might have room to tighten things up. Vertical analysis might be simple, but it’s a powerful tool for staying sharp and seeing your business from a new angle.
Example Table for Vertical Analysis
| Income Statement Line Item | ||
| Revenue | £100,000 | 100% |
| Cost of Goods Sold (COGS) | £40,000 | 40% |
| Gross Profit | £60,000 | 60% |
| Operting Expenses | £30,000 | 30% |
| Net Profit | £30,000 | 30% |
What This Tells You:
COGS is eating up 40% of your total revenue — is that high or low for your industry?
You’re keeping 30% as net profit, which is great — but what if operating expenses increase?
This analysis helps you track the weight of each cost compared to total income — all within one period.
Horizontal Analysis: Tracking Your Financial Story Over Time
If vertical analysis is about seeing your income statement items as percentages of revenue within a period, then horizontal analysis is all about comparing those numbers across different time periods — to spot trends, growth, or warning signs. Think of it like watching your business’s financial story unfold month by month, quarter by quarter, or year by year.
How Horizontal Analysis Works
You take a specific line item — say, revenue or net income — and compare it to the same item in a previous period. The goal? See how much it’s changed in amount and percentage terms.
Simple Formula for Horizontal Analysis
Change (%) =(Current Period Amount – Prior Period )÷Prior Period Amount
Example: Comparing Revenue Over Two Months
| Period | Revenue (£) | Change(£) | Percentage Change |
| March | 800,000 | – | – |
| April | 1,000,000 | 200,000 | 25% |
So, your revenue grew by £200,000 – or 25% from March to April. That’s a healthy jump!
But here’s where horizontal analysis really becomes powerful: it helps you spot unusual entries or changes you might otherwise overlook.
Example: Spotting Trouble Early
| Period | Operating Expenses (£) | Change(£) | Percentage Change |
| Q1 | 500,000 | ||
| Q2 | 650,000 | 150,000 | 30% |
A 30% jump in operating expenses might be fine if revenue is growing at the same pace — but if revenue stayed flat or even dropped, that’s a sign something’s off. And here’s where horizontal analysis really proves its worth: it helps you spot unusual entries or unexpected changes that you might otherwise miss.
For example, imagine you’re reviewing the latest income statement and suddenly see a large amount listed under Research and Development (R&D). But you know your business hasn’t done any R&D work lately — and there wasn’t any such expense in the previous period either. That kind of surprise line item is a red flag. Because you’re comparing periods side by side, you can immediately pick up on it, question it, and dig deeper. Whether it’s a one-off, a misclassification, or a bigger issue, this analysis puts you in a better position to catch it early, before it becomes a costly problem.
Key Takeaways
- The income statement helps you see how your business is doing — beyond just numbers on a page.
- Knowing what each section means (like revenue, COGS, and net income) gives you clarity on your earnings and spending.
- Simple tools like vertical and horizontal analysis help you spot trends and flag any issues early.
- You don’t need to be an expert — just curious enough to dig into the numbers.
What to Do Next
Pull up your most recent income statement and really look at it. Compare it to the last one. What changed? What stayed the same? Dig into the “why” behind the numbers. The more often you do this, the more confident you’ll get at spotting what matters.
Keep Going
Want to go deeper? Check out my post on Understanding the 3 Key Financial Statements. It ties the income statement, balance sheet, and cash flow together so you can see the full financial picture.
Final Note
Once this clicks, it changes how you see your business. You’ll stop guessing — and start making decisions backed by real insight.