The Mathematics of Money

Copyright © 2008, The McGraw-Hill Companies, Inc.

expected to follow certain rules. For statements filed with regulators or with

the Internal Revenue Service, certain standards must be followed; for state-

ments used internally by a business there may be more freedom but still cer-

tain standards are normally expected to be followed. In the United States,

the set of regulations known as generally accepted accounting practices

(GAAP; pronounced like the word “gap”) are just what their name implies.

It is worth noting, however, that for tax purposes businesses sometimes

may, or even must, report their financial results in ways that differ from

GAAP standards.

For all but the simplest businesses, financial statements are prepared by

accountants (small businesses sometimes use computer software instead

of hiring a human accountant). Obviously, this chapter is not designed to

provide a complete understanding of financial statements, nor is it intended

to equip you with everything you need to know to prepare a financial state-

ment for a business. We will, however, explore some key points and con-

cepts necessary to read and interpret a basic financial statement.

Basic Income Statements

The purpose of an income statement, as the name suggests, is to report on

a business’s financial performance over some period of time. An income

statement will show the money taken in by the business (its gross revenues

or gross sales), the expenses incurred by the business, and the net profit

or loss. The expenses are often separated into the cost of goods sold and

expenses (costs such as wages, rent, utilities, advertising expenses, and so

on). Subtracting the cost of goods sold from the gross income gives the

gross profit. Subtracting out the expenses leaves us with the net profit (or net income).

Here is a very simple example of an income statement:

Sammy’s Lemonade Stand

Second Quarter 2007 Income Statement

Sales $185.25


Cost of goods sold $75.35

Gross profi t $109.90


Expenses $45.00

Net income $64.90

From this statement, we see that Sammy sold $185.25 worth of lemonade in the quarter.

The lemonade he sold cost him $75.35 (for lemons, sugar, cups, etc.). Thus, his gross

profit, what he would have made if he had no expenses (overhead), was $109.90. Since

he did have expenses, though, we need to subtract that $45.00 to find that his net profit

was $64.90.

Example 12.1.1 Cattarauqua Ginseng Enterprises had sales of $176,530 last

year. The cost of the goods the company sold was $62,500 and its expenses totaled

$78,595. What was the company’s net income for the year?

We can set this information up as a simple income statement to calculate the net income:

Sales $176,530


Cost of goods sold $62,500

Gross profi t $114,030


Expenses $78,595

Net income $35,435

Depending on the intended audience and use for the financial statement, a greater level of

detail may be provided. The individual items that go into a category may be listed separately;

12.1 Income Statements 487

Financial statements are a valuable tool to analyze

a business’s performance. © David Young-Wolff/

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