AP Business with Personal Finance · Lesson 2

The income statement and the balance sheet

Know Know it

The income statement shows how a business performed over a period, such as a quarter or a year. It starts with revenue, the money earned from sales, and subtracts costs in layers.

Revenue - cost of goods sold = gross profit. Gross profit - operating expenses (rent, wages, marketing, utilities, depreciation) = operating income. Operating income - interest - taxes = net income, the bottom line.

Cost of goods sold is the direct cost of the products sold in the period: materials and the labor to make them, or what a store paid for the goods it resold. A margin divides a profit line by revenue. Gross margin = gross profit / revenue, and net profit margin = net income / revenue. Margins let you compare years, and businesses of different sizes.

The balance sheet is a snapshot on one date. It lists assets (what the business owns or is owed: cash, accounts receivable, inventory, equipment, buildings), liabilities (what it owes: accounts payable, loans) and owner's equity, the owners' claim. Assets = liabilities + owner's equity, so owner's equity = assets - liabilities. This is the business's book net worth, the same idea as a person's net worth.

Current assets are cash and items expected to turn into cash within a year; current liabilities are debts due within a year. Working capital = current assets - current liabilities, and the current ratio = current assets / current liabilities. Both show whether the business can pay the bills that come due soon.

Trap Gross profit is not the bottom line

Gross profit subtracts only the cost of goods sold. A shop can show a large gross profit and still post a net loss once rent, wages, interest and taxes come out. Find the line the question names before you subtract.

Worked example Easy

Fernwood Outfitters, a fictional store, had revenue of 250,000 dollars last year. Its cost of goods sold was 140,000 dollars, and its operating expenses were 70,000 dollars.

What was Fernwood's gross profit?

  1. 40,000 dollars
  2. 110,000 dollarsAnswer
  3. 180,000 dollars
  4. 460,000 dollars

How to solve it

  1. Gross profit uses only revenue and cost of goods sold.
  2. 250,000 - 140,000 = 110,000 dollars.
  3. Operating expenses come in on the next line, to get operating income.

Why each choice is right or wrong

  • A. Incorrect. 40,000 dollars also subtracts operating expenses, which gives operating income, a line below gross profit.
  • B. Correct. Gross profit = revenue - cost of goods sold = 250,000 - 140,000 = 110,000 dollars.
  • C. Incorrect. 180,000 dollars subtracts operating expenses instead of the cost of goods sold.
  • D. Incorrect. 460,000 dollars adds all three figures together; costs are subtracted from revenue, never added to it.

Explain Explain it

Task verbs: calculate, interpret

To calculate from a statement, write the formula in words, put in the numbers and label the result in dollars or percent. Then interpret: say what the number means for this business. Name the figure, give its value and say what it means for the business in the question, in words an owner or a lender would follow.

Worked example Medium

Income statement, Calloway Print Shop (fictional), one year

LineAmount (dollars)
Revenue400,000
Cost of goods sold220,000
Operating expenses120,000
Interest expense8,000
Income taxes16,000

What is the shop's net profit margin?

  1. 9 percentAnswer
  2. 13 percent
  3. 15 percent
  4. 45 percent

How to solve it

  1. Gross profit: 400,000 - 220,000 = 180,000 dollars.
  2. Operating income: 180,000 - 120,000 = 60,000 dollars.
  3. Net income: 60,000 - 8,000 - 16,000 = 36,000 dollars.
  4. Net profit margin: 36,000 / 400,000 = 0.09, or 9 percent.

Why each choice is right or wrong

  • A. Correct. Net income is 400,000 - 220,000 - 120,000 - 8,000 - 16,000 = 36,000 dollars, and 36,000 / 400,000 = 9 percent.
  • B. Incorrect. 13 percent leaves out income taxes: 52,000 / 400,000. Net income comes after taxes.
  • C. Incorrect. 15 percent is the operating margin (60,000 / 400,000), before interest and taxes are subtracted.
  • D. Incorrect. 45 percent is the gross margin (180,000 / 400,000), which subtracts only the cost of goods sold.

Calculate Your turn

A fictional bakery had revenue of 160,000 dollars this year. Its cost of goods sold was 96,000 dollars, operating expenses were 40,000 dollars, interest expense was 3,000 dollars and income taxes were 5,000 dollars. Last year its net profit margin was 12 percent. Calculate this year's gross profit and this year's net profit margin, showing your work, and explain what the change in the net profit margin from last year tells you.

Write it, then compare. Nothing you type here is saved or graded.

Compare with a model answer

A full answer does this

  • Gets gross profit of 64,000 dollars
  • Gets a net profit margin of 10 percent
  • Explains that the fall from 12 to 10 percent means the bakery kept less profit from each dollar of sales than last year

Model answer

Gross profit = 160,000 - 96,000 = 64,000 dollars. Net income = 64,000 - 40,000 - 3,000 - 5,000 = 16,000 dollars, so the net profit margin = 16,000 / 160,000 = 0.10, or 10 percent. The margin fell from 12 percent last year to 10 percent this year, so the bakery kept only about 10 cents of profit from each dollar of sales instead of 12 cents: its profit shrank relative to its sales.

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