How to Read an Income Statement Like a CFO

Most people glance at financial statements—Steve reads them like a playbook. In this video, he breaks down the income statement, balance sheet, and cash flow statement in plain, simple language that actually makes sense.

No jargon. No fluff. Just the essentials you need to understand what’s really happening in a business. Whether you’re a founder, operator, or just want to get better with numbers, this video will help you see your finances in a whole new way.

TRANSCRIPT:

Hey, it's Steve. In this video, I'm gonna walk you through how an income statement works from a CFO perspective. Now I'm going to abbreviate and keep things very high level so you can learn this content in a very efficient manner.

For starters, the income statement, also referred to as the profit and loss, or the P&L for short, essentially measures a company's revenues, expenses, and ultimately their profit and loss. The first line item on an income statement is revenue, also known as the top line or sales. And it represents the income that is generated by a company when they sell products and services to customers.

Now, underneath revenue, we have cost, which is just short for cost of goods sold, also known as cost of revenue. These are all the costs associated with producing and delivering products into the hands of customers. It may include accounts such as materials, direct labor, subcontractor costs, equipment maintenance costs, not the cost of the equipment, but the cost to maintain the equipment that is producing the product or service, and other indirect or direct costs associated with generating revenue.

All right, that's a big mistake that a lot of companies make is they have cost of goods sold, line items, down below mistakenly in operating expenses. And if a company does this, then they're gonna misstate the next line item, which is gross margin, also known as gross profit. Gross margin measures a company's ability to effectively price their products and services and then sell those products and services to customers while incurring costs that are associated with producing that revenue.

So you wanna have a nice, strong, healthy gross margin for the business because that's how the company is gonna remain viable. All right, underneath gross margin, we have OPEX, which is just a short way and a cool way of saying operating expenses, also known as overhead. Now, there's subcategories with OPEX such as selling general and administrative expenses, which may include items such as selling and marketing expenses, general and administrative payroll, professional fees, insurance, rent, utilities, and all other costs associated with running the business.

Would land here in SG&A, selling general and administrative. You also may have depreciation and amortization rolled up underneath OPEX. Now, every company is different.

For example, there are some businesses in the oil and gas industry, and they may have their depreciation and amortization listed up above in cost of goods sold. There's some flexibility as it pertains to GAAP, which stands for Generally Accepted Accounting Principles in the United States, which provides guidance and standards for companies when they are putting together their financial statements. So some businesses may record things up above and some may record it down below.

As long as it meets GAAP standards, it's all good. All right, so that's OPEX, operating expenses. And underneath OPEX, we arrive at operating profit.

The key word here is operating because we wanna measure profit that is generated through the normal operations of the business. So we take revenue minus cost of goods sold. We end up with gross margin.

We account for OPEX. And we arrive at operating profit. This excludes the line items down below and other income and expense.

These are items that are not a part of normal operations of the business. For example, other income may include interest income. And unless you're a bank in the business of earning interest income as a revenue source, most companies are gonna record interest income down below in other income.

Or let's say you're a business and you got PPP money in the United States. You wouldn't wanna record that up above in revenue because that's not a part of normal operations. So you would record one-off items down below in other income.

Or if you sell a piece of equipment and there's a gain on that piece of equipment, it'd be other income. The same thing is true with other expense. Interest expense, for example, is not a part of normal operations.

So it'd be recorded down below here. Or if you have a loss on a piece of equipment or you have another expense that is just non-recurring that is not a part of normal operations, you'd wanna capture it down below in other expense. After we account for these items, we arrive at net income.

This is commonly referred to as the bottom line. Now, here's the deal. This is very nuanced.

So I'm gonna keep things very high level. But if you are a sole proprietor or an LLC or an S-corp, these entities are referred to as disregarded entities because they don't pay income tax or corporate tax in their businesses. Instead, this net income flows through on the K-1 in the United States to the investor's individual tax returns because the company's not paying taxes.

Instead, this net income is flowing to the owners of the business. Now, if the company is a C-corporation, they do pay tax and you may see corporate taxes broken out on the income statement here, all right? But for most businesses, this is the general structure of the income statement. Now, before I get into some bonus content here, if this is making sense to you, can I get a yes in the comments box below?

Also, are there other questions that you have on your mind? If so, can you put those questions or provide feedback down below in the comments because then I'll know what content I should produce in the future to help you out even further.

All right, let's get into some bonus items here. As a CFO, when I evaluate an income statement, I'll look at things in dollar terms and as a percentage of revenue. So let me just put some numbers here for simplicity's sake.

I'll use nice round numbers and let's say the company has $1,000 in revenue, $600 in cost of goods sold, 1,000 minus 600 would leave me $400 in gross profit. And then let's say operating expenses combined are 300. That leaves me with operating profit of 100 and then I have other income and expense netted out at $10, which leaves me $90 of net income, all right? I'm just simplifying here so you can understand it in contextual terms here.

So now let's go and express all these numbers as a percentage of revenue. So if you're doing this in Excel, you can take each of these cells and divide it by revenue. Just lock it on revenue here.

And so revenue divided by revenue is 100%. Like I said, we're gonna divide everything by revenue. Cost of goods sold divided by revenue is gonna be 60%.

400 divided by revenue, the 1,000, is gonna be 40%. And I'm just gonna go down the line. Everything is divided by revenue.

So I can express all this in terms of revenue. So that's one of the first things I do on the income statement is I express everything as a percentage of revenue. And then I can start right-sizing the financials.

This is really helpful because if I'm comparing one period to the next, then I can see things on a percentage basis how they're trending. Now for this company, let's say they're earning a 9% bottom line. Let me ask you this.

What do you think is the average profitability of a business? Drop that down below in the comments box. I wanna hear what you're thinking here. Don't worry, there's no shame in whatever answer you put down there.

Most people don't get this right. But I would say generally speaking, all right, this is very general, an average healthy profit for a company is around 10%. So this business right here, a pretty good business.

Now for some companies, like when I was in construction, as a CFO of a large construction firm, our net income was around 2%. All right, so some industries are gonna have a smaller net income, and that's fine. Tech companies or other businesses that have a competitive advantage are gonna have a much bigger bottom line, especially as a percentage of revenue.

Now, how do you know if your company has a competitive advantage? You know I can't do a video without talking about strategy because I'm a big believer that strategy plus finance drives value. Okay, you can't have either of those in isolation. So how do you know if your company has a good strategy and a strong competitive advantage? The way you do that is by putting everything as a percentage of revenue, looking at this bottom line right here, and then comparing it to your industry average.

And better yet, comparing this number to your competitive set, the competitors that are competing for the same customers in which you are. So if I look at this, and let's just say the industry average is 12%, and my profit is 9%, that means I don't have a competitive advantage because I'm earning profits below industry average. Now, this isn't anything to worry about because you can always put in place a better strategy and you can make moves in your business to change this number and drive better margins.

But it's important to understand how you compare to your competitive set and the overall industry in which you compete. So I like to understand this number. So whatever business you're in or whatever industry you're competing in, make sure you understand what the industry average is.

All right, there's one other thing that I wanna point out here, and it's called the X factor. Now, the way you compute the X factor in your business is you take net income, I'll write this out here, X factor, and I'm just gonna erase this industry average right here. The X factor is gonna be your revenue divided by your net income.

So if you take $1,000 of revenue and you divide it by 90 in net income, it equals about 11.1 X. What this means is that for every dollar you earn in net income, you have to do 11.1 times in sales. The reason why this is so important to calculate is because it will frame so many conversations and it will change the mindset of your team as they look at giving discounts or incurring costs or generating revenue or performing other activities in the business that drive value.

When I had my landscape company back in the day, I started my first company when I was 16 years old, I grew it into a multimillion dollar business, and there were times where my employees were lackadaisical with just our equipment out in the field.

So for example, we'd have these landscape rakes, these big giant rakes, and they would cost over $100. Let's just say $100 each, and they would oftentimes run these rakes over with the tractors because they were just sitting in the dirt and the driver of the tractor would just plow right over them. Well, when I did this exercise with my company, at the time, we had an X factor of around 20% because our profit was 5%, so five divided by our revenue gave us a 20X X factor.

If we take that $100 rake, that's our cost, and we multiply it by our X factor down here, which was 20 at the time, then it'd be 20 times $100, which is $2,000. That's how much revenue we have to go earn as a company in order to pay for that rake because we're gonna earn $2,000 in revenue, but then we incur all those costs to just make $100 to cover that rake. And when I started communicating this widely across the company, eyes started to open.

So you could do the same thing in your company, and it's important to understand what your X factor is because it will help change the way you look at costs.

One other example here pertains to discounts. I always talk about driving value through price premiums, cost and capital efficiencies, and strategic growth, and that's how strategy and finance work together to maximize firm value. Now, a big part of that is pricing.

Remember, when value exceeds price, customers buy. When price exceeds value, customers don't buy because the price is higher than the perceived value they're expected to receive. So what do companies do? Well, instead of putting in place a solid strategy, they reduce their price.

Now, let's take this example right here of 11.1. And let's say this business sells a high-ticket product, and they have to discount it by $1,000 in order to sell the product. So they're selling it for $1,000, and they multiply it by their X factor, 11.1. That means they have to go sell an additional $11,100, which is $1,000 times their 11.1 X factor in order to make up for the discount that they're giving that customer.

See how this has a massive impact on a business? And just multiply this case by all the times it occurs in your business, and you can see how offering discounts can be detrimental for your business.

But at the end of the day, this is how I walk through an income statement. This is how I express it in a percentage of revenue. And be sure to check out my other videos so you can continue to boost your financial and strategic IQ.

If you got value out of this video, I would love it if you share it with your network, and also be sure to subscribe so you get notified every time I drop a new video. And in the meantime, take care of yourself. Cheers.