Peter and Paul are kid brothers with a dream: to quench the thirst of their neighborhood (and make a few bucks while they’re at it). Their grand plan? A lemonade stand! Their family, bless their entrepreneurial hearts, love the idea. Their mother, ever the supportive investor, lends them $400. They must pay 0.5% interest every month (6%/year) on the borrowed amount. “It builds character,” she says. Their dad helps them to buy some hardware, which costs $200. Their uncle, a master craftsman (or so he claims), helps to build the stand and signs, for which he charges $50 (upon the insistence of Peter’s parents, who believe in teaching the kids the value of a dollar, even within the family). The location is their parents’ front yard, for which the kids have to pay rent of $30/month. Talk about a tough landlord! I wish more parents would treat their children like this. Heck I wish I would treat my children like this more often!
The kids spend another $20 on containers and utensils, an ice box, a dustbin (gotta keep things tidy!) and a few other things. These are one-time costs. It’s a seasonal business. Lemonade sells well in summer (who knew?), so the business operates for 3 months in the summer each year. Their recurring costs are $40/month for lemons, sugar, disposable glasses, and napkins. They sell lemonade only on Saturdays and Sundays for 2 hours each day. Their revenues (or sales) are $400/month, which is roughly $23/hour. Not bad for a couple of kids! The kids don’t pay taxes because their profits are small and a benevolent local law exempts them from having to identify as a business.
The following is the income statement of the lemonade stand:
An income statement has three main parts:
- Revenue
- Expenses
- Profits
Revenues or sales are the money that the business brings in, in this case the money from selling lemonade. If you have heard the term “top line”, this is it. It appears at the top of the income statement. If revenues are the top line, net income is the “bottom line”. Net income means profit, that which is left after all costs and claims have been paid. Between the top and bottom lines there are many line items for various expenses that a business must bear.
There are also intermediate measures of profitability such as “Gross Profit”, “EBITDA”, and operating income or “EBIT”.
- Gross profit is what is left of revenues after subtracting the cost of producing the goods sold. In this case, the gross profit is lemonade sales minus cost of lemons, sugar, glasses etc.
- EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) subtracts some more costs such as wages of employees, but it does not subtract interest, tax, depreciation or amortization.
- EBIT (Earnings Before Interest and Tax), also referred to as operating income subtracts depreciation and amortization but not interest and tax.
Why do people care about so many incomplete measures of profitability? First, these measures allow the examiner to get a better sense of where the money in a business is going. Second, sometimes a specific measure is suited for a particular purpose. For example, EBIT looks at a business’ core earnings power after stripping away the impact of tax policy and leverage (interest). The same basic business can produce quite different profits by borrowing different amounts of money. In this example, did Peter and Paul really need to borrow $400? A well-known book on investing titled The Little Book That Beats the Market uses EBIT in a formula to identify high quality businesses, and shows that such businesses in aggregate do tend to outperform. That said, in times of excess, some of these incomplete measures are abused to paint rosy pictures of imaginary profitability; EBITDA, in particular, is criticized in this regard.
So, while Peter and Paul’s lemonade stand is a simplified example, it illustrates the core principles of business finance. Hopefully, this breakdown has demystified the income statement and given you a clearer picture of how to track revenue, expenses, and ultimately, profit. Perhaps it will even inspire you to help the young entrepreneurs in your own life learn these valuable skills! Now, if you’ll excuse me, I’m suddenly craving a glass of lemonade.
Thanks for reading. If you like my writing, please share my blog and consider following me on Twitter.